The Unreasonable Endurance Of The Efficient Market Hypothesis

This past year or so I've become very interested in the ideas behind equity investing and devoted a considerable amount of time to understanding the various philosophies and strategies adopted by some of the world's most successful investors. I view the selection and timing of investment in securites as a great intellectual challenge, requiring expertise in a wide variety of disciplines ranging from business and economics to more subtle relationships like mathematics and psychology. Being a serial learner constantly drawn to a wide range of subjects, this idea of applying knowledge and skills from tons of different subject areas to be able to reason intelligently about something as complex as the stock market had a lot of appeal to me. As I began to dive deeper, I quickly became acquainted with what arguably poses the most foundational question imaginable about the nature of the stock market: the efficient market hypothesis.

The basic idea behind the efficient market hypothesis, or EMH, is that asset prices fully reflect all available information. Whatever the price of an equity is today represents the true value of that company based on all publicly-available information, and any new information that comes out is immediately priced in to the stock. There are several variants of the theory that play with different levels of stringency on what the word "efficiency" means, but they all adhere to this basic framework. The ultimate implication of the theory is that the market is rational, that "inefficiences" are quickly corrected, and that it is not possible to reliably and consistently earn excess returns.

Let's disect this a bit because there are several different perspectives through which we can examine EMH. The first is what I'll call the "academic" perspective. This is a broad set of theories that try to base their formulation of EMH on sound mathematical and economic understanding. The idea is that we have this really complex thing called the stock market and we need some model to be able to explain how it works, so we come up with things like CAPM (capital asset pricing model) and MPT (market portfolio theory) to try to generalize what we see happening empirically. The undercurrent to these theories is that expected returns are explicitly tied to risk. Make more risky investments and you have a chance at higher returns. Make conservative investments and the potential for profit is reduced. Theories falling under this category assume that some form of EMH holds; in other words, the market is rational.

A different way to look at EMH is through the lens of behavioral finance. The core idea of behavioral finance is that humans tend to act irrationally on occassion and irrational behavior can lead to inefficiences in the market. Behavioral finance was pioneered by guys like Daniel Kahneman and asserts that anomalies such as trends and asset bubbles can largely be attributed to cognitive biases and other human errors in reasoning and information processing. Tendencies such as overconfidence, information bias, herd mentality, etc. can lead investors to do things that logically may not make sense and thus can break the supposed rationality of the market.

The final way we can examine EMH is from the perspective of fundamental analysis, or "value" investing. This is the school of thought that was championed by Ben Graham in the early 1900s, and later by his most famous student, Warren Buffett. There are lots of different ways to describe the ideas put forward by Graham, Buffett, and the many other hyper-successful investors that used fundamental analysis to achieve their success. But the foundational idea of value investing is very simple: to buy shares of great companies at attractive prices. Value investors analyze the fundamentals of a business - earnings, cash flow, growth, return on capital etc. They dig into the details of how the business works, how it's positioned in its market, how efficient it is, how well it's managed, what the prospects are for its industry, and so on. In doing so, they identify opportunities to purchase portions of a business that they believe are worth more than the market does (with an appropriate margin of safety).

While behavioral finance provides some contrarian evidence against EMH, it's not 100% incompatible with at least the weaker forms of the theory. Value investing, on the other hand, basically spits in the face of EMH. In order for value investing to work at all, by definition there must be securities that are mis-priced - i.e. the market cannot be rational. And while there is no known theoretical framework or mathematical model that explains the stock market from a fundamentals perspective, the empirical results are decidedly in favor of fundamental analysis. There is perhaps no better example of this than Warren Buffet's 1984 essay The Superinvestors of Graham-And-Doddsville.

Throughout the essay, Buffet shows case after case of investors that beat the market averages by very wide margins over long periods of time, and demonstrates that these investors all shared a common intellectual origin. This is important because a common explanation for extraordinary investment success is that statistically it is expected that there will be outliers so these cases are consistent with EMH. However, for this thesis to hold the outliers must be independent and identically distributed. Warren showed very clearly in the essay that this assumption is false. In 1991 Seth Klarman (another very successful value investor) wrote a book in which he stated "Buffett's argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what was refuted in practice".

While I presented the behavioral finance in value investing perspectives separately, in reality they've always been somewhat tied together. Even Ben Graham's early work recognized the effect that investor psychology could have on the markets and the opportunites that it could create. This was evident in his famous caricature of the stock market as a manic-depressive gentlemen called "Mr. Market" - a guy who from day to day may choose to buy or sell securities at vastly different prices depending on his mood that day. Graham understood that for human beings, absolute logic and rationality does not always come easy, and the market is a function of human behaviors and tendencies.

So where do things stand today? The stock market is certainly more liquid than it's ever been. Information is more freely available than at any time in history. According to the academic view, the case for the efficient market hypothesis should be stronger than ever. And yet, time and again, investors practicing a value-oriented philosophy of purchasing quality businesses for less than they're worth are able to beat the market in the long run. The case that Buffet made in his essay more than 30 years ago still seems to hold true. But despite this seemingly apparent contradiction of EMH, the theory is still quite popular while fundamental analysis remains somewhat of a niche style of investing. Why is this the case?

I think there are a couple things driving the continued belief in EMH. Investing in general is a relatively complicated thing and most individuals do not have the time or energy to devote to really understanding even some of the more basic concepts in investing. To someone who has not gone down that path of learning about alternative theories in investing, EMH intuitively seems to make sense. The average investor probably views the stock market as something that tons of professionals all over the world are constantly analyzing and number crunching, shrewdly capturing any inefficiencies as soon as they happen. From that perspective, it would be logical to conclude that the market must be efficient and a simple "retail" investor would have no chance of competing.

Another reason EMH is still widely believed is because it is often still taught in schools. In the academic world, at least to my knowledge, some form of EMH is still believed to be true and so students taking classes on business, economics etc. still learn about things like CAPM, MPT and so on. As new generations of students are brought up believing that EMH holds, it's likely that those beliefs become part of a self-reinforcing cycle. By that I mean, investors who assume the market is efficient will invest in ways that probably reinforce the idea that the market is efficient. You can't begin with the premise that the market is efficient and then empirically arrive at the conclusion that it is not based on your own personal results, unless the investment decisions that led to those results were based on a rejection of the idea of an efficient market in the first place!

That leads to my last point about why the efficient market hypothesis is so enduring. Believeing that it is false is actually somewhat difficult. Assuming that markets are efficient is the natural state for one to subscribe to, and running contrary to that belief requires evidence. But evidence that the market is NOT efficient is hard to come by. By that I don't mean that it's hard to find - there are plently of examples such as Warren's essay mentioned earlier that provide convincing evidence against EMH. But it's one thing to read about past instances of seemingly convincing examples that happened to someone else. It's quite a different thing to tangibly and empirically witness it yourself, which is very challenging to do. Even if it is the case that some stocks are undervalued in the market, that doesn't make it easy to find them or invest in them with a long enough time horizon to see those investments truly pay off.

Believing in the idea that it's possible to beat the market takes both a willingness to go against conventional wisdom and the conviction to stick with your hypothesis even when it doesn't always work. Most people do not have this temperament. The ideas that Graham, Buffet et al. have put forth are simple ideas, but they are not easy to follow. This is perhaps the biggest reason why EMH persists. It's much easier to assume that markets are efficient than to convince yourself otherwise. And as long as investors continue believing in an efficient market, there will continue to be discrepencies between price and value for intelligent investors to exploit.