The Paradox of the Efficient Market Hypothesis

The Paradox of the Efficient Market Hypothesis

The debate over the validity of the efficient market hypothesis (EMH) has been an ongoing debate for decades, since Jules Regnault and Louis Bachelier implemented models that supported this theory.  The theory was later referred to as a “random walk”, which signified that price patterns could not be anticipated, similar to a pebble being kicked by someone taking a walk.  These changes in prices combined with the psychology of the erratic range emotions created prices to evolve in ways that would be unpredictable.  Although it is strongly argued by many that prices are simply the by-products of how much a security is worth, there are multiple gaping holes that have allows intelligent investors to thrive.  Within the active financial markets of investors, there are two main types of investors: growth investors who believe in the EMH, and value investors, who do not buy into this theory.   The purpose of this paper is to deeply identify, analyze, and to establish conclusions to thriving efficiencies in the EMH and to bring to light the rewards and risks or costs that investors must manage in terms of their investing psychology and how their beliefs in the EMH causes shifts in behavioral finance.

Before we discuss the paradox of the EMH, let us define the three versions of this hypothesis, which are known as the weak-form hypothesis, semistrong, and strong form of the hypothesis.  The weak form of the hypothesis assets that stock prices already reflect the information that can be obtained if the investor analyzed data in the financial market.  This version argues that results from securities and data in financial markets instantly give the investor accurate data; that the market is “being honest” in the present moment.  The semistrong-form is a more intensified version of the prior argument, stating that all public information must already be reflected in the stock price.  Finally, the strong-form EMH argues that the market takes into account all insider activity, as well as the semistrong and the weak-form hypothesis.

For the plethora of investors who believe that the EMH exists and that the price truly reflects the value of the underlying security, study technical indicators and growth trends.  The perception that these investors have is to purchase shares of a stock when it is about to gain momentum and almost always when bull markets are present.  This is called technical analysis, which author Zvi Bodie defines this investing style as “is the research on recurrent and predictable stock price patterns and on proxies for buys or sells pressure in the market.”  Early work from this type of analysis dates back to 1933, when Cowles began analyzing the predictions from analysts who forecasted trends, from January 1928 to June 1932.  As a result, Cowles did not discover any statistically significant forecasting performance.

In taking a deeper look into the validity of technical investing, there are factors that help this investor, but also cause the investor to deny opportunities that present in the macroeconomic markets.  For example, growth investors follow certain rules: buy high and sell higher, cut your losses below a certain percentage drop, analyzing chart patterns, and even to avoid investing into a bear market at all costs does not challenge the validity of the EMH, but blindly follows behind it.  On one hand, these rules or “standards” cause the investor to focus only on the opportunities within a bull market and also to only invest into stock prior to peak times, which ignores the distinction between understanding what is a broken stock versus recognizing a broken company.  This “ignorance” of not delving into the possibility that there could be tremendous value and rewards by defying the financial markets causes investors to miss out on the gains in which value investors are able to capitalize on.

In reading “From the Efficient Market Hypothesis to Behavior Finance,” by Adam Szyszka, he points out weaknesses by stating the following.  “According to the behavioral approach market is not always efficient and investors who make a better an average use of available information are able to make abnormal returns.  Active trading strategies might be indeed better in some cases than passive “buy & hold”.   He goes on to clarify that active investors should take notice that they “also may be a subject of behavioral biases and heuristics”.   Thus, he concludes, would be to the technical investor’s advantage if he were to assert not just analysis and new strategies, but “self-control”.  Szyszka makes a strong point that investors who have accumulated years of experience should not take their rules of growth investing so dogmatically or haphazardly, but should prioritize their focus more on their emotions in the moment; not to react to an attractive cup-and-handle stock chart.

On the flip side of the coin, investors who engage in fundamental analysis take on the role of committing to the style of value investing.  This fundamental analysis is defined as the use of earnings and dividend from a firm, along with an analysis of the company’s financial statements.  In contrast to analyzing the behavior of a stock chart, the value investor is deeply aware and prepared with his analysis on macroeconomic trends and the intrinsic value of how much an underlying security is truly worth.  It is particularly true that, on average (since the Great Depression), value investors who “bought low and sold high” were able to capitalize on a higher range of price differences between buying and selling the asset(s).  However, there is room in this argument for debate.  These investors would ignore raging bull markets and deny the possibility to take on any additional risk in the 1990s, when companies such as AOL American Online was rising in the market.  Perhaps investors who practice value investing and denied the EMH theory made money, but it certainly took years while growth investors and traders were in a position to take on a more speculative approach.

In reading The Intelligent Investor: the Definitive Book on Value Investing, by Benjamin Graham, the author debates the relevance for considering the EMH.  “Our statement that the current price reflects both known facts and future expectations was intended to emphasize the double basis for market valuations.  Every competent analyst looks forward to the future rather than backward to the past, and he realizes that his work will prove good or bad depending on what will happen and not on what has happened.  Nevertheless, the future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of protection.”  The benefits that value investors have when defying the EMH is that they are taking responsibility for their complete fundamental analysis: to cultivate their behavior to have a negative or zero relationship relative to the patterns and trends in the financial markets.

Taking these two mind-sets of investing should give the intelligent investor awareness that there is great potential between the false dichotomy.  As Graham also argues against the hypothesis as more and more smart investors search for bargains, he argues that “the very act of searching for bargains, in a cruel paradox, makes the analysts seem as if they lack the intelligence to justify the search.”  Specifically, he holds the belief that an “intelligent investor” must be committed to not only go against the crowed, but sometimes against his own methods.  If, for example, the mobile industry if beginning to boom, the intelligent investor would benefit more by investing into the next industry that is undervalued, but would more than likely move towards reflecting its intrinsic value or price.

In learning about the misconceptions of the EMH, there has been active research as to how effective the EMH stands alone, without taking in the comparison between technical or fundamental investors.  Between 1990 and 2002, The Wall Street Journal ran a contest that compared investment decisions between investors who picked stocks against the results of a dart hitting random stocks on a board.  After 147 contests that lasts approximately 6-months each, the investors won 90 games and lost 57.  In analyzing this contest to hold the validity of the EMH, there represents a problem.  Perhaps investors who discovered the stock picks expected these investors to win, since the dart would land on an average risky asset, while the investors pick greater-than-average risky assets.  Another problem that could be probable was that many investors could purchase these securities soon after the contest, causing a self-fulfilling prophecy in the increase of the underlying investments.  Unfortunately, there is no way to repeat these results under the same exact conditions, but it could at least support at least partial evidence that the EMH holds true, at least more than half of the time during this contest.

References

Graham, Benjamin. The Intelligent Investor (2006 edition). Retrieved from (p.363)

Szyszka, Adam. From the Efficient Market Hypothesis to Behavior Finance.

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