Is the stock market efficient or not? Investing question answered

Moneycone.com asked, “Are markets efficient or not?”

After spending a few minutes thinking about how I would tackle this widely researched topic, I decided to do what any researcher would do, I went to Google and typed in, “Are markets efficient or not?”

300 million responses later, I am no less daunted. This question is one of the most widely debated investing questions.

What is the efficient market hypothesis?

The efficient market hypothesis was created by Noble prize winner, Eugene Fama.

According to Morningstar.com, the efficient market hypothesis is:

“A market theory that evolved from a 1960’s Ph.D. dissertation by Eugene Fama, the efficient market hypothesis states that at any given time and in a liquid market, security prices fully reflect all available information. The EMH exists in various degrees: weak, semi-strong and strong. This theory contends that since markets are efficient and current prices reflect all information, attempts to outperform the market are essentially a game of chance rather than one of skill.”

The three types of efficient market

Weak stock market efficiency

The efficient market hypothesis (EMH) is broken down into the “weak form” which states that stock prices reflect all publicly available information.

Semi-strong stock market efficiency

The “semi-strong form” of the EMH includes the weak form and adds that stock prices also adjust rapidly to the release of all new public information. Practically, this means that stock prices adjust so quickly to information that investors can’t profit from a technical analysis (analyzing past stock price trends and movements) or even from fundamental analysis.

Strong stock market efficiency

The third type of the EMH, the “strong form” includes the weak and semi-strong and adds on insider information. If the markets were “strong form” efficient, then investors couldn’t profit from securing insider information. We know that markets are not “strong form” efficient because it is so widely accepted that investors can profit from insider information, that it is illegal to trade on insider information.

So, we’ve ruled out the possibility that markets are “strong form” efficient, but are they weak or semi-strong form efficient?

In other words, can investors make a profit greater than is expected by the riskiness of the security?

The index fund industry, spearheaded by John Bogle and Vanguard Investments states that investors are well served to invest in a diversified portfolio of index funds and that they will beat active and professional investors most of the time.

This sounds almost too simple to be possible, and there is loads of research that supports that finding. Yet, not everyone buys into the simple EMH theory, including Nobel prize winner, Robert Shiller.

‘Is the stock market efficient?’ controversy

If markets were proven to be completely efficient, then investors wouldn’t look to exploit market inefficiencies.

Shiller challenges the EMH with evidence that markets move away from their fair price and create over or undervalued scenarios. Think about the internet bubble of the late 1990’s. Even now, in late 2017, stocks seem to be more highly valued than their historical averages.

During stock market bubbles, such as in the late 1990’s stock average PE (price earnings) ratios skyrocket driving prices way above fair value as defined by companies’ underlying business models.

Shiller was among the forecasters who warned us about overvalued assets during the dot-com boom and the more recent housing price bubble in the middle of last decade.

Market anomalies may also cause question about the efficient market hypothesis. These anomalies seem to persist over the long term in financial markets. (Be aware that they may persist over the long term, but in short periods of time there is no consistency to support that the market anomalies always “outperform.”)

Do stock market anomalies disprove the efficient market hypothesis?

A good strategy in the stock market is to invest in a diversified portfolio of index funds rather than focusing on just one type of stock. (Source)

What is a stock market anomaly?

“In financial markets, anomalies refer to situations when a security or group of securities perform contrary to the notion of efficient markets, where security prices are said to reflect all available information at any point in time.” — Investopedia.com

Stock market anomalies include:

1. Momentum. A stock going up in price usually continues to go up (or down) even past the point of “fair value”.

2. Value stocks. Lower valued stocks usually appreciate more than overvalued stocks.

3. Small-cap stocks. Small cap stocks usually outperform larger capitalization stocks.

4. The January effect. Stocks usually go up in January.

But, do these anomalies disprove the efficient market hypothesis? Or are there logical explanations that explain the incidence of outperformance other than the fact the markets are not efficient?

Why market anomalies don’t disprove the efficient market hypothesis

The Investor’s Business Daily founder, William O’Neil is a big proponent of the momentum approach and it is true that for a period, stocks do seem to continue moving in the same direction.

Frequently, investors overreact to a positive or negative news incident causing the company’s stock price to deviate from fair value. The problem with making an outsized gain, above that predicted by markets, is persistence.

Can an investor, over time, beat the EMH by investing in momentum stocks? It is unlikely because, at some point, momentum stops and share price returns to fair value. A successful momentum investor must be correct twice; when to buy in and when to sell.

Small stocks usually grow faster than large stocks. Practically speaking, if a company sells $10 billion per year, in order to grow 10 percent they would need to sell $100 million more in the next year. That’s a lot of sales.

But, if a company sells $5 million in a year, they only need to increase sales by $500 thousand in order to grow 10%. Earning $500 thousand is much easier than selling $100 million more products or services. Thus, it’s only logical that a small company is going to grow faster than a larger one.

At the end of the year, many investors sell stocks with losses in order to benefit from the capital loss on their taxes. Thus, in January, they buy back stocks to remain in the markets—a simple explanation for the January effect.

If you want to capitalize on the market anomalies, put some money into a small cap and value ETF.

Are markets efficient or not?

I’ve taught the “efficient market hypothesis” in an Investments class at Santa Clara University and Lebanon Valley College. The conclusion is not a simple one.

If investors could make a profit greater than market returns most of the time, that would disprove the efficient market hypothesis.

Can investors outperform markets over the long term without taking an outsized risk (or without being overly lucky)? Can they continue to beat the markets year after year?

Maybe.

But, if there are investors beating the markets year in and year out, without taking large risks, they probably aren’t telling. After all, if these extraordinary investors divulge their methodology, then their advantage would disappear. Maybe a few investors such as Warren Buffett or George Soros beat the odds, but not many.

The efficient market investing takeaway

After decades of investing in the markets, picking stocks, and index funds, I’m convinced that over the long term an index fund approach, in line with one’s risk tolerance is the most effective way to invest.

A passive index fund investing strategy is easy to implement and market returns are good.

It’s unlikely that over the long term you can beat the market returns.

Stocks have averaged about nine percent over the last 80 years or so and bonds about five percent.

If you do want to try to outperform the markets, go with indexing for the majority of your portfolio. Invest 10 to 15 percent of your financial assets with an active strategy.

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DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation in writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.