ORIGINS OF THE EMH

While the term was coined in the 1960s, the concept of market efficiency predates this by many years. It isn't clear who first came up with the idea, but this quote from George Gibson in 1889 shows it was long before 20th-century academics:

[When] shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them.⁴¹

Even Dow theorist Robert Rhea believed in the concept of informational efficiency, as the following quote from his 1932 book The Dow Theory shows:

The Averages Discount Everything: The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite index of all the hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movement. The averages quickly appraise such calamities as fires and earthquakes.⁴²

Though the concept had been understood for a long time, it wasn't until the 20th century that academics started undertaking research on market efficiency and crunching some numbers. Bachelier kicked things off in 1900, but his work lay unacknowledged for decades — that is, until its rediscovery in the 1950s, which provided impetus to the growing academic interest in market efficiency. One leading academic at the time was Paul Samuelson, a brilliant economist from the Massachusetts Institute of Technology. The story of how Samuelson rediscovered Bachelier's turn-of-the-century thesis is an interesting one.

It starts with American mathematician Leonard ‘Jimmie' Savage. To describe Savage as smart isn't paying him his full due. In his younger days he had compensated for Albert Einstein's deficiencies in mathematics by working as the great physicist's numbers man. Noted economist Milton Friedman described Savage as ‘one of the people whom I have met whom I would label a genius'.⁴³

In 1954 Savage was nosing around in the Yale Library when he came across a copy of Bachelier's thesis, reproduced in a 1914 French book. As Savage thumbed the pages between its dusty covers, he recognised the significance of Bachelier's work. He also realised there were a number of academics who would be more than interested in Bachelier's ground-breaking formulae. To spread the news of his exciting find he sent out a dozen or so postcards carrying the message (later paraphrased by Samuelson): ‘Do any of you economist guys know about a 1914 French book on the theory of speculation by some French professor named Bachelier?'

When Samuelson received his postcard from Savage he went looking for the book in the MIT Library. This is where the story gets a bit confused. In the foreword to a 2006 book entitled Louis Bachelier's Theory of Speculation, Samuelson wrote that the library at MIT didn't possess Savage's 1914 reference but it did have something better — a copy of Bachelier's original thesis. Yet in an interview, in the documentary The Midas Formula: Trillion Dollar Bet, Samuelson said:

In the early 1950s I was able to locate, by chance, this unknown book by a French graduate student in 1900 rotting in the library of the University of Paris. And when I opened it up it was as if a whole new world was laid out before me. In fact as I was reading it I arranged to get a translation in English because I wanted every precious pearl to be understood.

No reference to Jimmie Savage in this story. Specifics of how Samuelson actually came across Bachelier's thesis aside, we at least know that the rediscovery of Bachelier's calculations stimulated further interest in the subject of market pricing efficiency. The irony is that when Bachelier first presented his thesis to the Faculty of Sciences of the Academy of Paris on 29 March 1900 he was awarded the second-tier ‘mention honorable', insufficient to win him an academic appointment at the university. It seems no-one then recognised what Bachelier's work offered — a mathematical formula that came remarkably close to describing how the market prices of financial securities behave in real life. Bachelier died in 1946, eight years before Savage's rediscovery of his work. He never had the chance to hear the accolades ultimately paid to him.

EUGENE FAMA

The term ‘Efficient Market Hypothesis' is attributed to Chicago professor Eugene Fama. He studied, researched and further developed the efficiency concepts already proposed by others and published papers on them in the 1960s and 1970s. Fama's PhD thesis was published in the January 1965 issue of the Journal of Business. He concluded, as Bachelier had, that short-term stock price movements were random and therefore unpredictable. He proposed that the market price represented the best estimate of what a stock was worth at any point in time, and that it incorporated all available information about that stock. Any attempt by a lone investor to derive a more appropriate value was nothing more than an exercise in futility.

When Fama's work became public, it struck a chord. Here was a reason why many experienced investors found it impossible to consistently beat the market — something John Bogle, founder of the Vanguard Group, had come to realise years earlier. Bogle was a student at Princeton University back in 1949. Like many students he faced the problem of coming up with an idea for his university research paper. He decided to study the investment returns achieved by professional fund managers, and he found that after fees, and considered as a group, they failed to outperform the broad index. He figured that, since the index could be reproduced without undertaking any form of financial analysis, it would be far simpler to run a fund that aimed to match the index rather than beat it. It was these findings that ultimately led him to establish Vanguard's highly popular index funds.

If the efficient market theorists were correct, then the active fund managers weren't adding any value to the investment process. Of course the fund managers chose not to agree, particularly the successful ones. They'd respond: ‘Don't throw averages at me. The results of my fund have been well above average. Just look at the league tables.'

But statistics are a wonderful thing. You don't have to shuffle them around for too long before finding numbers to suit your case. Consider the following. Gather a hundred people in a hall. Ask each to flip a coin one hundred times and record the result of each flip. Tell them the winner is the person who flips the most tails. I'm sure you'll appreciate that at the end of the exercise there won't be 100 flippers who have each flipped 50 heads and 50 tails. Some might have flipped 45 heads and 55 tails, some 45 tails and 55 heads. The laws of normal distribution apply. An outlier of 35 heads and 65 tails might be achieved, so winning the competition. I guess you can see where I'm heading with this one: luck can be obscured by vanity.

Fama and a colleague, Kenneth French, undertook a very interesting study looking at this whole issue of luck and performance. Their paper, ‘Luck versus Skill in the Cross Section of Mutual Fund Returns', examined the investment returns delivered by actively managed US mutual funds between 1984 and 2006, focusing on funds invested primarily in US equities.⁴⁴

Their first finding was one many earlier studies had also made — that, taken as a group, there was no evidence that active managers were capable of outperforming the index. And when management fees were included, returns were actually lower than the index delivered. Unfortunately, many people interpret statements like this as meaning that no fund manager is capable of outperforming the market. Clearly this fails to acknowledge that different skill levels can exist within a group. The smartest kid in the class doesn't want to be defined by the average class grade, just as the fund manager who achieves the highest investment return doesn't want to be told they're incapable of beating the market index. But is their outperformance of the market due to skill or luck?

To test this, Fama and French constructed a theoretical distribution of outcomes for a population of funds where chance alone determined the outcome. They ran this simulation 10 000 times and aggregated the results. Just like our hypothetical coin-flipping competition, there were winners and losers. If these results were presented in the real world, some of the fund managers would have been hailed as investing gurus, while some might have gone out of business. The most interesting finding of the study was the similarity between the simulated outcomes and the outcomes delivered by real-life fund managers. So similar were they that it places fund managers' claims of superior performance as being due to superior skill in extreme doubt. It doesn't prove that it's totally due to luck, but it certainly raises significant doubt that it's entirely due to skill.

So if luck can get a fund manager into the winner's circle, the moral of the story is that ‘successful' managers need to make a lot of noise when they find themselves on top of the league tables, because it's unlikely they'll stay there for long.^a

Interestingly, Fama has also gone on public record as saying that stock analysis isn't a total waste of time, but that very few investors are capable of gaining an edge from doing it. In the following quote he acknowledges that those with significant skill and an ability to think independently are likely to gain an edge:

If there are many analysts who are fairly good at this sort of thing, however, and if they have substantial resources at their disposal, they help narrow discrepancies between actual prices and intrinsic values and cause actual prices, on the average, to adjust ‘instantaneously' to changes in intrinsic values … Although the returns to these sophisticated analysts may be quite high, they establish a market in which fundamental analysis is a fairly useless procedure both for the average analyst and the average investor.⁴⁵

Not everyone would agree with Fama that prices, on the average, ‘adjust “instantaneously” to changes in intrinsic values'. Many would say that discrepancies between price and value can endure for longer periods.

MAKING SENSE OF THE EMH

How do we resolve some apparent contradictions that the EMH throws up? How, for example, do stock market crashes occur?

How can stock prices drop by 50 per cent in a matter of months only for everyone to later say it was because the stock market had previously been overpriced? Yet, on the other hand, why is the stock market efficient enough that most market professionals are incapable of beating it?

I like the way Warren Buffett reconciles this apparent contradiction. On referring to the efficient marketeers he said: ‘Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.'

In other words, Buffett becomes more interested in the market when it's characterised by a significant degree of inefficient pricing, but he acknowledges that this is far from all the time. Fischer Black (of Black–Scholes option-pricing model fame) addressed the same issue in a paper titled ‘Noise':

All estimates of value are noisy, so we can never know how far away price is from value. However we might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value. The factor of 2 is arbitrary, of course. Intuitively, though, it seems reasonable to me, in the light of sources of uncertainty about value and the strength of the forces tending to cause price to return to value. By definition, I think almost all markets are efficient almost all the time. ‘Almost all' means at least 90%.⁴⁶

The message I hear from the efficient marketeers sounds confused to me. There are those who see it as applying all the time, and there are those who say there are exceptions, times when it doesn't apply. Even Samuelson, a strong advocate of market efficiency, had this to say in his 1974 paper ‘Challenge to Judgment':

It is not ordered in heaven, or by the second law of thermodynamics, that a small group of intelligent and informed investors cannot systematically achieve higher mean portfolio gains with lower average variabilities. People differ in their heights, pulchritude, and acidity. Why not in their P.Q. or performance quotient?⁴⁷

It seems the Buffetts of this world are capable of identifying inefficient stock pricing, which makes sense. For example, could not inefficient pricing occur during periods when markets are driven by extremes of emotion? When people are emotional, they fail to behave rationally. What's more, the process of socialisation leads people to react en masse, leading to widespread irrational behaviour and distortion of market prices. Efficiency should be limited to those times when investor behaviour is on a more rational plane. This helps explain Buffett's observation that markets display efficiency most of the time but not all the time. This is all that the patient investor requires: for the market to be inefficient some of the time, and to use those times to act. It also helps to explain why extended periods of inactivity are the hallmark of successful investors.

Chapter summary

• At most times the valuation of stocks by well-informed investors tends to protect those investors who either haven't formed or are incapable of rationally forming their own view on value.
• The concept of market efficiency has been considered for more than a century.
• Academics and financial market participants embraced Eugene Fama's Efficient Market Hypothesis as outlined in his PhD thesis, published in the January 1965 issue of the Journal of Business.
• The concept of market efficiency underpinned the expansion of index funds.
• Research undertaken by Fama and French suggests that luck could play a significant part in determining fund manager performance.
• While market efficiency might explain stock price movement most of the time, it's unlikely to explain stock prices when emotions are strong.