Sunday, 11 March 2012

Efficient Market Hypothesis: Fact Or Fiction? "Efficient" refers to informational efficiency only.

The efficient markets hypothesis (EMH) in all of its forms, whether strong, semi-strong, or weak, is normative, not positive, i.e., it is an assertion about the way markets should behave in an ideal, utopian world, not a statement about the way markets actually do work in the real, practical world. Simple observation shows that the EMH in all its forms is fallacious. Both Kindleberger and Mackay give historical examples of stock market irrationality and inefficiency.
The efficient markets hypothesis may have advanced many academic careers, but it has not demonstrably increased the wealth of any investor over what would have been created otherwise. The EMH and the related capital asset pricing model, as opposed to the operating enterprise valuation model, may be useful as a standard of market perfection in studies of the market as a whole, but not in the valuation or selection of common stocks for investment.

The term "efficient" in the efficient markets hypothesis refers to informational efficiency only. It does not include mechanical operational efficiency or necessarily societal welfare efficiency.
The EMH explicitly assumes that all market participants have access to the same information in either a strong, semi-strong, or weak sense of the hypothesis.

  • This simplifying assumption is chosen because it is necessary for mathematical tractability and thus highly convenient. 
  • What makes this assumption unacceptably implausible is the meaning of the term "information" which is often overlooked. 
  • Data is not information. Rather, information is data that has been processed and interpreted with judgment based on intelligence, knowledge and experience. 
  • Does anyone believe that all market participants are endowed equally, not with access to data, but with the same intelligence, knowledge and experience? 
Competitive, properly-regulated markets may approach the semblance of "data efficiency" in the relative sense of eliminating arbitrage opportunities subject to trading costs and taxes, but no market is efficient in any absolute sense of equating price at all times to intrinsic economic value. This margin between value and price is the major key to successful value investing.

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