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Course 502
Efficient Market Theory

Introduction

Given the seemingly nonsensical price swings in the stock market, it's hard to believe that anyone could call the stock market "efficient." Yet that's exactly what Burton Malkiel did in his 1973 book, A Random Walk Down Wall Street.

This course explains what efficient market theory is, explores the arguments against it, and shows what the theory has to do with your portfolio.

What Efficient Market Theory Is

Efficient market theory--or as it's technically known, Efficient Market Hypothesis--is an attempt to explain why stocks behave the way they do.

The hypothesis holds that stock prices reflect all the publicly available information about companies. Stock prices aren't necessarily "right," but they're as correct as they possibly could be. As a result, says Malkiel, "a chimpanzee throwing darts at The Wall Street Journal can select a portfolio that performs as well as those managed by the experts."

Given how broad the original Efficient Market Hypothesis (EMH) was, a noted academic, Eugene Fama, later divided the theory into three subhypotheses.

The weak-form EMH assumes that current stock prices fully reflect all historical information, including past returns. Thus investors would gain little from technical analysis, or the practice of studying a stock's price chart in an attempt to determine where the stock price is going to go in the future.

The semi-strong EMH form assumes that stock prices fully reflect all historical informationandall current publicly available information. Thus, investors gain little from fundamental analysis, or the practice of examining a company's financial statements and recent developments.

Finally, the strong-form EMH states that prices reflect not just historical and current publicly available information, but insider information, too. Investors therefore can't benefit from technical analysis, fundamental analysis, or insider information

The Conclusions of Efficient Market Theory

Let's take an example. Company Asells at $53 per share. According to efficient market theory, that $53 price tag takes into account all factors that affect the stock, including the company's growth history up until that time, such as its profitability, the quality of its management, and what analysts were predicting the company would earn in the future.

Efficient-market theorists don't claim that any one investor thinks about all these things when buying stocks. Maybe some investors bought Company A because they liked what management said in its latest earnings release, or because they liked the company's products. But the activity of all investors, which is what actually drives the stock's price, collectively reflects all of those factors.

What's the practical application of this theory? Because the market is efficient, with prices moving so quickly as new information comes out about a company, no one can consistently buy and sell quickly enough to benefit from the information. As a result, neither you nor professional money managers can beat the market for an extended period of time. Instead of trying to beat the market, say efficient market theory's supporters, you should just index, or buy and hold all the stocks in the market.

Strikes Against Efficient Markets Theory

In the 1980s, academics challenged the theory. And the October 1987 stock market crash left economists, money managers, and investors asking: "Did the market accurately reflect all publicly available information about these companies before the crash? If so, how could the crash have happened?"

Even Malkiel himself admitted in the sixth edition of A Random Walk(published in 1995) that "while the reports of the death of the efficient-market theory are vastly exaggerated, there do seem to be some techniques of stock selection that may tilt the odds of success in favor of the individual investor."

Some of the more-notable studies that threw the weak-form EMH into question included research by Eugene Fama and Kenneth French. The duo found that buying stocks that have performed poorly during the past few years led to superior returns over the next few years.In other words, a strategy of buying unpopular stocks can lead to better results than a strategy of buying popular stocks. That's because the market can get carried away with fashionable stocks, and pessimism can be overdone.

Academics uncovered stock-market patterns that questioned the semi-strong EMH, too. They found that stocks with low price/earnings and/or price/book multiples produce above-average returns over time.

Finally, researchers have shown how stock splits, dividend increases, insider buying, and merger announcements can dramatically affect stock prices, thereby proving false the strongest-form EMH.

The Upshot

So is EMH a has-been? Perhaps. But the question for you as an investor is whether you can effectively take advantage of the market anomalies that challenge EMH. Pricing irregularities do exist. So do predictable patterns. But there's no guarantee that they'll continue, nor that you (or your fund managers) will be able to spot them and take advantage of them.

If you believe in EMH, then you should be indexing the market. If you don't believe in EMH, then you should pick your own stocks, or pay mutual fund managers to choose stocks for you. If you see merit in both sides, index part of your portfolio and actively pick stocks with the other part of it. Investing doesn't have to be a choice between efficient market theory and active management. There's room in your portfolio for both.

Quiz 502
There is only one correct answer to each question.

1 What does efficient market theory say about stock prices?
a. That they reflect all publicly available information about the companies.
b. That they're irrational and do not reflect publicly available information about the companies.
c. That stocks with low price/earnings multiples outperform.
2 The semi-strong EMH assumes what?
a. That stock prices fully reflect all historical information, including past returns.
b. That stock prices fully reflect all historical information and all current publicly available information.
c. That stock prices reflect not just historical and current publicly available information, but insider information, too.
3 Which statement is true?
a. EMH attempts to explain why stocks behave the way that they do.
b. EMH argues that you or your mutual fund manager can take advantage of inefficiencies in the stock market.
c. EMH says that technical analysis works.
4 What findings threw EMH into question?
a. That stocks with high price/earnings multiples tend to outperform.
b. That stocks that are popular tend to outperform.
c. That stocks that are unpopular tend to outperform.
5 If you believe in EMH, what should you do?
a. Index the market.
b. Choose active mutual fund managers who can take advantage of inefficiencies in the market.
c. Invest in both indexed and actively managed mutual funds.
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