Efficient-market hypothesis

The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information. Since risk adjustment is central to the EMH, and yet the EMH does not specify a model of risk, the EMH is untestable.[1] As a result, research in financial economics since at least the 1990s has focused on market anomalies, that is, deviations from specific models of risk.[2]

The idea that financial market returns are difficult to predict goes back to Bachelier (1900),[3] Mandelbrot (1963),[4] and Samuelson (1965).[5] Eugene Fama is closely associated with the EMH, in part due to his influential 1970 review of the theoretical and empirical research (Fama 1970).[1]

Despite its lack of testability, the EMH still provides the basic logic for modern risk-based theories of asset prices. Indeed, modern frameworks such as consumption-based asset pricing and intermediary asset pricing can be thought of as the combination of a model of risk with the hypothesis that markets are efficient.[6]

Theoretical background

Suppose that a piece of information about the value of a stock (say, about a future merger) is widely available to investors. If the price of the stock does not already reflect that information, then investors can trade on it, thereby moving the price until the information is no longer useful for trading.

Note that this thought experiment does not necessarily imply that stock prices are unpredictable. For example, suppose that the piece of information in question says that a financial crisis is likely to come soon. Investors typically do not like to hold stocks during a financial crisis, and thus investors may sell stocks until the price drops enough so that the expected return compensates for this risk.

How efficient markets are (and are not) linked to the random walk theory can be described through the fundamental theorem of asset pricing. This theorem states that, in the absence of arbitrage, the price of any stock is given by

where is the expected value given information at time , is the stochastic discount factor, and is the dividend the stock pays next period. Note that this equation does not generally imply a random walk . However, if we assume the stochastic discount factor is constant and the time interval is short enough so that no dividend is being paid, we have


Taking logs and assuming that the Jensen's inequality term is negligible, we have

which implies that the log of stock prices follows a random walk (with a drift).

Empirical studies

Research by Alfred Cowles in the 1930s and 1940s suggested that professional investors were in general unable to outperform the market. During the 1930s-1950s empirical studies focused on time-series properties, and found that US stock prices and related financial series followed a random walk model in the short-term.[7] Whilst there is some predictability over the long-term, the extent to which this is due to rational time-varying risk premia as opposed to behavioral reasons is a subject of debate. In their seminal paper, Fama, Fisher, Jensen, and Roll (1969) propose the event study methodology and show that stock prices on average react before a stock split, but have no movement afterwards.

Weak, Semi-Strong, and Strong-Form Tests

In Fama's influential 1970 review paper, he categorized empirical tests of efficiency into "weak-form", "semi-strong-form", and "strong-form" tests.[1] These terms, however, are rarely used in academic research beyond the 1980s. Indeed, Fama later said he "came to regret" using these terms.[8] Fama's 2013 Nobel prize address on the topic almost completely ignores these concepts.[6] Reviews of the asset pricing literature from the 2000s and 2010s also ignore these concepts.[9][10] Focus on these categories of efficiency has been replaced by a focus on the risk model assumed (see the joint hypothesis problem).

Despite the disappearance of this terminology from academic journals, undergraduate textbooks continue to emphasize weak vs strong forms of efficiency, as do investing websites like Investopedia.[11]

These categories of tests refer to the information set used in the statement "prices reflect all available information." Weak-form tests study the information contained in historical prices. Semi-strong form tests study information (beyond historical prices) which is publicly available. Strong-form tests regard private information.[1]

Historical background

Benoit Mandelbrot claimed the efficient markets theory was first proposed by the French mathematician Louis Bachelier in 1900 in his PhD thesis "The Theory of Speculation" describing how prices of commodities and stocks varied in markets.[12] It has been speculated that Bachelier drew ideas from the random walk model of Jules Regnault, but Bachelier did not cite him,[13] and Bachelier's thesis is now considered pioneering in the field of financial mathematics.[14][13] It is commonly thought that Bachelier's work gained little attention and was forgotten for decades until it was rediscovered in the 1950s by Leonard Savage, and then become more popular after Bachelier's thesis was translated into English in 1964. But the work was never forgotten in the mathematical community, as Bachelier published a book in 1912 detailing his ideas,[13] which was cited by mathematicians including Joseph L. Doob, William Feller[13] and Andrey Kolmogorov.[15] The book continued to be cited, but then starting in the 1960s the original thesis by Bachelier began to be cited more than his book when economists started citing Bachelier's work.[13]

The efficient markets theory was not popular until the 1960s when the advent of computers made it possible to compare calculations and prices of hundreds of stocks more quickly and effortlessly. In 1945, F.A. Hayek argued that markets were the most effective way of aggregating the pieces of information dispersed among individuals within a society. Given the ability to profit from private information, self-interested traders are motivated to acquire and act on their private information. In doing so, traders contribute to more and more efficient market prices. In the competitive limit, market prices reflect all available information and prices can only move in response to news. Thus there is a very close link between EMH and the random walk hypothesis.[16]

The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson had begun to circulate Bachelier's work among economists. In 1964 Bachelier's dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Cootner.[17] In 1965, Eugene Fama published his dissertation arguing for the random walk hypothesis .[18] Also, Samuelson published a proof showing that if the market is efficient, prices will exhibit random-walk behavior.[19] This is often cited in support of the efficient-market theory, by the method of affirming the consequent,[20][21] however in that same paper, Samuelson warns against such backward reasoning, saying "From a nonempirical base of axioms you never get empirical results."[22] In 1970, Fama published a review of both the theory and the evidence for the hypothesis. The paper extended and refined the theory, included the definitions for three forms of financial market efficiency: weak, semi-strong and strong (see above).[23]


Investors, including the likes of Warren Buffett,[26] and researchers have disputed the efficient-market hypothesis both empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel Kahneman, Amos Tversky and Paul Slovic and economist Richard Thaler. These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks.

Empirical evidence has been mixed, but has generally not supported strong forms of the efficient-market hypothesis[27][28][29] According to Dreman and Berry, in a 1995 paper, low P/E stocks have greater returns.[30] In an earlier paper Dreman also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta,[31] whose research had been accepted by efficient market theorists as explaining the anomaly[32] in neat accordance with modern portfolio theory.

Behavioral psychology

Behavioral psychology approaches to stock market trading are among some of the more promising alternatives to EMH (and some investment strategies seek to exploit exactly such inefficiencies). But Nobel Laureate co-founder of the programme Daniel Kahneman —announced his skepticism of investors beating the market: "They're just not going to do it. It's just not going to happen." Indeed, defenders of EMH maintain that Behavioral Finance strengthens the case for EMH in that it highlights biases in individuals and committees and not competitive markets. For example, one prominent finding in Behaviorial Finance is that individuals employ hyperbolic discounting. It is demonstrably true that bonds, mortgages, annuities and other similar financial instruments subject to competitive market forces do not. Any manifestation of hyperbolic discounting in the pricing of these obligations would invite arbitrage thereby quickly eliminating any vestige of individual biases. Similarly, diversification, derivative securities and other hedging strategies assuage if not eliminate potential mispricings from the severe risk-intolerance (loss aversion) of individuals underscored by behavioral finance. On the other hand, economists, behaviorial psychologists and mutual fund managers are drawn from the human population and are therefore subject to the biases that behavioralists showcase. By contrast, the price signals in markets are far less subject to individual biases highlighted by the Behavioral Finance programme. Richard Thaler has started a fund based on his research on cognitive biases. In a 2008 report he identified complexity and herd behavior as central to the global financial crisis of 2008.[33]

Further empirical work has highlighted the impact transaction costs have on the concept of market efficiency, with much evidence suggesting that any anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring the valuable information in order to trade on it. Additionally the concept of liquidity is a critical component to capturing "inefficiencies" in tests for abnormal returns. Any test of this proposition faces the joint hypothesis problem, where it is impossible to ever test for market efficiency, since to do so requires the use of a measuring stick against which abnormal returns are compared —one cannot know if the market is efficient if one does not know if a model correctly stipulates the required rate of return. Consequently, a situation arises where either the asset pricing model is incorrect or the market is inefficient, but one has no way of knowing which is the case.

The performance of stock markets is correlated with the amount of sunshine in the city where the main exchange is located.[34]

A key work on random walk was done in the late 1980s by Profs. Andrew Lo and Craig MacKinlay; they effectively argue that a random walk does not exist, nor ever has.[35] Their paper took almost two years to be accepted by academia and in 1999 they published "A Non-random Walk Down Wall St." which collects their research papers on the topic up to that time.

EMH anomalies and rejection of the Capital Asset Pricing Model (CAPM)

While event studies of stock splits are consistent with the EMH (Fama, Fisher, Jensen, and Roll, 1969), other empirical analyses have found problems with the efficient-market hypothesis. Early examples include the observation that small neglected stocks and stocks with high book-to-market (low price-to-book) ratios (value stocks) tended to achieve abnormally high returns relative to what could be explained by the CAPM.[27][28] Further tests of portfolio efficiency by Gibbons, Ross and Shanken (1989) (GJR) led to rejections of the CAPM, although tests of efficiency inevitably run into the joint hypothesis problem (see Roll's critique).

Following GJR's results and mounting empirical evidence of EMH anomalies, academics began to move away from the CAPM towards risk factor models such as the Fama-French 3 factor model. These risk factor models are not properly founded on economic theory (whereas CAPM is founded on Modern Portfolio Theory), but rather, constructed with long-short portfolios in response to the observed empirical EMH anomalies. For instance, the "small-minus-big" (SMB) factor in the FF3 factor model is simply a portfolio that holds long positions on small stocks and short positions on large stocks to mimic the risks small stocks face. These risk factors are said to represent some aspect or dimension of undiversifiable systematic risk which should be compensated with higher expected returns. Additional popular risk factors include the "HML" value factor (Fama and French, 1993); "MOM" momentum factor (Carhart, 1997); "ILLIQ" liquidity factors (Amihud et al. 2002). See also Robert Haugen.

View of some economists

Economists Matthew Bishop and Michael Green claim that full acceptance of the hypothesis goes against the thinking of Adam Smith and John Maynard Keynes, who both believed irrational behavior had a real impact on the markets.[36]

Economist John Quiggin has claimed that "Bitcoin is perhaps the finest example of a pure bubble", and that it provides a conclusive refutation of EMH.[37] While other assets used as currency (such as gold, tobacco) have value independent of people's willingness to accept them as payment, Quiggin argues that "in the case of Bitcoin there is no source of value whatsoever".

Tshilidzi Marwala surmised that artificial intelligence influences the applicability of the theory of the efficient market hypothesis in that the more artificial intelligence infused computer traders there are in the markets as traders the more efficient the markets become.[38][39][40]

Warren Buffett has also argued against EMH, most notably in his 1984 presentation The Superinvestors of Graham-and-Doddsville, saying the preponderance of value investors among the world's best money managers rebuts the claim of EMH proponents that luck is the reason some investors appear more successful than others.[41] However, as Malkiel[42] has shown, over the 30 years prior to 1996 more than two-thirds of professional portfolio managers have been outperformed by the S&P 500 Index and, more to the point, there is little correlation between those who outperform in one year and those who outperform in the next.

In his book The Reformation in Economics, economist and financial analyst Philip Pilkington has argued that the EMH is actually a tautology masquerading as a theory.[43] He argues that, taken at face value, the theory makes the banal claim that the average investor will not beat the market average—which is a tautology. When pressed, proponents will then say that any actual investor will converge with the average investor given enough time and so no investor will beat the market average. But Pilkington points out that when proponents of the theory are presented with evidence that a small minority of investor do, in fact, beat the market over the long-run, these proponents then say that these investors were simply 'lucky'. Pilkington argues that introducing the idea that anyone who diverges from the theory is simply 'lucky' insulates the theory from falsification and so, drawing on the philosopher of science and critic of neolcassical economics Hans Albert, Pilkington argues that the theory falls back into being a tautology or a pseudoscientific construct.[44]

Paul Samuelson argued that the stock market is "micro efficient" but not "macro efficient", in that the EMH is much better suited for individual stocks than it is for the aggregate stock market. Research based on regression and scatter diagrams has strongly support Samuelson's dictum.[45]

Late 2000s financial crisis

The financial crisis of 2007–08 led to renewed scrutiny and criticism of the hypothesis.[46] Market strategist Jeremy Grantham stated flatly that the EMH was responsible for the current financial crisis, claiming that belief in the hypothesis caused financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking".[47] Noted financial journalist Roger Lowenstein blasted the theory, declaring "The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis."[48] Former Federal Reserve chairman Paul Volcker chimed in, saying it's "clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations [and] market efficiencies."[49] One financial analyst noted "by 2007–2009, you had to be a fanatic to believe in the literal truth of the EMH."[50]

At the International Organization of Securities Commissions annual conference, held in June 2009, the hypothesis took center stage. Martin Wolf, the chief economics commentator for the Financial Times, dismissed the hypothesis as being a useless way to examine how markets function in reality. Paul McCulley, managing director of PIMCO, was less extreme in his criticism, saying that the hypothesis had not failed, but was "seriously flawed" in its neglect of human nature.[51][52]

The financial crisis led Richard Posner, a prominent judge, University of Chicago law professor, and innovator in the field of Law and Economics, to back away from the hypothesis. Posner accused some of his Chicago School colleagues of being "asleep at the switch", saying that "the movement to deregulate the financial industry went too far by exaggerating the resilience—the self healing powers—of laissez-faire capitalism."[53] Others, such as Fama, said that the hypothesis held up well during the crisis and that the markets were a casualty of the recession, not the cause of it. Despite this, Fama has conceded that "poorly informed investors could theoretically lead the market astray" and that stock prices could become "somewhat irrational" as a result.[54]

Efficient markets applied in securities class action litigation

The theory of efficient markets has been practically applied in the field of Securities Class Action Litigation. Efficient market theory, in conjunction with "fraud-on-the-market theory", has been used in Securities Class Action Litigation to both justify and as mechanism for the calculation of damages.[55] In the Supreme Court Case, Halliburton v. Erica P. John Fund, U.S. Supreme Court, No. 13-317, the use of efficient market theory in supporting securities class action litigation was affirmed. Supreme Court Justice Roberts wrote that "the court’s ruling was consistent with the ruling in "Basic" because it allows "direct evidence when such evidence is available” instead of relying exclusively on the efficient markets theory."[56]

See also


  1. Fama, Eugene (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work". Journal of Finance.
  2. Schwert, G. William (2003). "Anomalies and market efficiency". Handbook of the Economics of Finance.
  3. Bachelier, L. (1900). "Théorie de la spéculation". Annales Scientifiques de l'École Normale Supérieure. 17: 21–86. doi:10.24033/asens.476. ISSN 0012-9593.
  4. Mandelbrot, Benoit (January 1963). "The Variation of Certain Speculative Prices". The Journal of Business. 36 (4): 394. doi:10.1086/294632. ISSN 0021-9398.
  5. Samuelson, Paul A. (23 August 2015), "Proof that Properly Anticipated Prices Fluctuate Randomly", The World Scientific Handbook of Futures Markets, World Scientific Handbook in Financial Economics Series, 5, WORLD SCIENTIFIC, pp. 25–38, doi:10.1142/9789814566926_0002, ISBN 9789814566919
  6. Fama, Eugene (2013). "Two Pillars of Asset Pricing" (PDF). Prize Lecture for the Nobel Foundation.
  7. See Working (1934), Cowles and Jones (1937), and Kendall (1953), and later Brealey, Dryden and Cunningham.
  8. "Fama on Finance: Interview on EconTalk with Russ Roberts".
  9. Barberis, Nicholas (2018). "Psychology-based Models of Asset Prices and Trading Volume". doi:10.2139/ssrn.3177616. ISSN 1556-5068. Cite journal requires |journal= (help)
  10. Schwert, G. William (2003), "Chapter 15 Anomalies and market efficiency", Financial Markets and Asset Pricing, Handbook of the Economics of Finance, 1, Elsevier, pp. 939–974, doi:10.1016/s1574-0102(03)01024-0, ISBN 9780444513632
  11. Bodie, Zvi; Kane, Alex; McDonald, Robert (March 1983). "Inflation and the Role of Bonds in Investor Portfolios". Cambridge, MA. doi:10.3386/w1091. Cite journal requires |journal= (help)
  12. "Benoit mandelbrot on efficient markets (interview - 30 September 2009)". www.ft.com. Financial times. Retrieved 21 November 2017.
  13. Jovanovic, Franck (2012). "Bachelier: Not the forgotten forerunner he has been depicted as. An analysis of the dissemination of Louis Bachelier's work in economics" (PDF). The European Journal of the History of Economic Thought. 19 (3): 431–451. doi:10.1080/09672567.2010.540343. ISSN 0967-2567.
  14. Courtault, Jean-Michel; Kabanov, Yuri; Bru, Bernard; Crepel, Pierre; Lebon, Isabelle; Le Marchand, Arnaud (2000). "Louis Bachelier on the Centenary of Theorie de la Speculation" (PDF). Mathematical Finance. 10 (3): 339–353. doi:10.1111/1467-9965.00098. ISSN 0960-1627.
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  16. Kirman, Alan. "Economic theory and the crisis." Voxeu. 14 November 2009.
  17. Cootner (ed.), Paul (1964). The Random Character of StockMarket Prices. MIT Press.CS1 maint: extra text: authors list (link)
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  19. Samuelson, Paul (1965). "Proof That Properly Anticipated Prices Fluctuate Randomly". Industrial Management Review. 6: 41–49.
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    • Francis Nicholson. Price-Earnings Ratios in Relation to Investment Results. Financial Analysts Journal. Jan/Feb 1968:105–109.
    • Basu, Sanjoy (1977). "Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A test of the Efficient Markets Hypothesis". Journal of Finance. 32 (3): 663–682. doi:10.1111/j.1540-6261.1977.tb01979.x.
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  31. Ball R. (1978). Anomalies in Relationships between Securities' Yields and Yield-Surrogates. Journal of Financial Economics 6:103–126
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  42. Malkiel, A Random Walk Down Wall Street, 1996
  43. Pilkington, P (2017). The Reformation in Economics: A Deconstruction and Reconstruction of Economic Theory. Palgrave Macmillan. Pp261-265.
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  45. Jung, Jeeman; Shiller, Robert (2005). "Samuelson's Dictum And The Stock Market". Economic Inquiry. 43 (2): 221–228. CiteSeerX doi:10.1093/ei/cbi015.
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  51. "Has 'guiding model' for global markets gone haywire?". Jerusalem Post. 11 June 2009. Archived from the original on 8 July 2012. Retrieved 17 June 2009.
  52. Stevenson, Tom (17 June 2009). "Investors are finally seeing the nonsense in the efficient market theory". The Telegraph.
  53. "After the Blowup". The New Yorker. 11 January 2010. Retrieved 12 January 2010.
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  55. Sommer, Jeff (28 June 2014). "Are Markets Efficient? Even the Supreme Court Is Weighing In". The New York Times.
  56. Liptak, Adam (23 June 2014). "New Hurdle in Investors' Class Actions". The New York Times.


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