The Efficient Market Hypothesis… has two components that I like to refer to with the terms No Free Lunch and The Price Is Right. The No Free Lunch component says that it is impossible to predict future stock prices and earn excess returns except by bearing more risk. The Price Is Right component says that asset prices are equal to their “intrinsic value,” somehow defined. 

–  Richard Thaler, “From Cashews to Nudges:The Evolution of Behavioral Economics”, American Economic Review  2018 

Times have changed. Bashing the efficient market hypothesis has become a pastime within the academic and hedge fund communities. What was once a foundational principle in finance has been has been cut down to size by behavioral finance. In the marketplace, the premise of all hedge fund investing is that markets are inefficient and can be exploited by a manager’s unique skill and edge.

Nevertheless, the efficient markets hypothesis (EMH) should still be a starting point for any discussion about market behavior or the ability of managers to make money. The EMH should be an investor’s base case or prior from which he look for exceptions or alternatives. Start with the premise that there is no skill or edge and ask to be proved otherwise.

Richard Thaler does a nice job of providing a simple updated definition of EMH and how his thinking fits within this hypothesis in his Noble Prize lecture in 2017. For his two-part definition, the “no free lunch” component is simple. In a competitive market with no barriers to entry, it is hard to earn excess returns.  Any better “mousetrap” for finding profits will not be able to last before the market takes away the edge. Normal profits are zero beyond the return for bearing risk. Anyone who looks at the structure of markets should believe there are a lot of smart people trying to gain an edge and it is not easy. Information processing is very quick, so prices respond immediately to new information. The second part states that prices represent true value. All that competition is able to generate the intrinsic price. Prices have to equal intrinsic value otherwise excess returns can be exploited. Markets are able to process information efficiently. His career work finds that there are exceptions to these rules.

While this is a good working prior, it does not mean that markets are efficient at all times and prices will also equal intrinsic value. There can be free lunches and deviations from intrinsic value because of the limits of arbitrage and from behavior that does not process information effectively and makes errors in judgment.

Our ability to define intrinsic value is compromised because the concept of value is hard to measure. There are simple example where investors are not able to do simple math for finding relative value and deeper example where value is just elusive.  Similarly, our behavior may generate consistent mistakes which can be exploited. There may exist an ebb and flow between true rationality and actual behavior. Markets will move away from intrinsic value only to return after being stretched to an extreme.

So how should an investor behave given this changing concept of efficiency?

  • Accept that markets are competitive, so an edge is hard to find.
  • It is difficult to generate excess returns after accounting for risk.
  • Accept that any manager skill like an edge is rare.
  • If there is skill or edge, it may not last.
  • Use the EMH as a prior or base case, but accept that anomalies can exist. However, these exceptions may only be identifiable ex post.
  • Behavioral biases exist which can generate repeatable opportunities. Competition may not drive out all of the investors who have biases and the biases that dominate may change over time.
  • Price will deviate from intrinsic value because there are limits to arbitrage.
  • There will be noise around intrinsic value
  • Prices may deviate from intrinsic value because there is not always agreement on value or beliefs. Price are weighting of opinions.
  • Price deviations from intrinsic value may not last, but any closure of deviation may not be immediate.

The efficient market hypothesis may be out of fashion and has been proven not to hold as tightly as believed. Thaler and others have proved that market behavior is more complex than described by EMH, but the EMH should still be a good foundational guide for what can possibly be achieved through active management.