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Efficiency Market Hypothesis (EMH): Understanding the Pivotal Theory in Finance

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efficiency market hypothesis (emh)

Efficiency Market Hypothesis (emh) Definition

The Efficient Market Hypothesis (EMH) is a financial theory suggesting that all available information about a particular investment, like stocks or bonds, is instantly and fully reflected in that asset’s current market price, making it nearly impossible to consistently achieve higher than average market returns through trading strategies. Essentially, it posits that markets are always perfectly efficient and it’s impossible to ‘beat the market’ because prices already incorporate and reflect all relevant information.

Understanding the Three Forms of EMH

Weak form efficiency.

The weak form of the Efficient Market Hypothesis (EMH) posits that current stock prices fully incorporate all available security market information. In essence, it indicates that past trading data, such as prices, volume of trading or rates of return, cannot be used to outperform the market. This idea fundamentally devalues the use of technical analysis, a method that uses past data for future investment decisions.

The assumptions underlining the weak form of EMH are that:

  • All past market prices and data are publicly available at no cost.
  • Market participants are rational and react instantaneously to any new piece of information.

Consequently, the implications are that no gains can be achieved using technical analysis. The only way to outperform (earn a higher return than) the market is by either luck or through the acquisition of inside information, which is illegal.

Semi-Strong Form Efficiency

In the semi-strong form of EMH, current stock prices do not just reflect past trading information but also all publicly available information. This includes financial statements, announcements, economic factors, and anything else accessible to the public that could potentially influence stocks.

The key assumptions in this form are that:

  • All publicly available information about an asset is instantly reflected in its market price.
  • No one can achieve consistently high trading returns through fundamental analysis, which involves examination of company’s financial statements and health, its management, competitors and market conditions.

This means the markets adjust quickly to absorb new information, so trading on or immediately after announcements will not lead to consistently stellar returns.

Strong Form Efficiency

The strong form of EMH claims that stock prices reflect all information, both public and private, meaning even insider information is completely factored into the market prices. In essence, no one, not even those with inside information, could have an advantage in predicting the stock prices.

Under the strong form of EMH:

  • All information (public and private) is fully reflected in asset prices.
  • No investor will be able to consistently achieve abnormal return in the market, neither by using past publicly available information nor inside or private information.

This implies that markets are completely efficient, and the only way to achieve higher returns consistently is by chance. This form of EMH is broader and quite controversial, given it's hard to verify and it discounts the idea that insider trading provides a beneficial edge.

Efficiency vs. Inefficiency in Market Hypothesis

In the context of economics, the terms market efficiency and market inefficiency stand in opposition to each other. They describe different states of market, where all available information gets reflected in asset prices.

In an efficient market , prices fully reflect all available information. Imagine a scenario where a company has just announced a new, hugely profitable business venture. In an efficient market, this company’s stock price would instantly adjust to reflect this positive news.

This happens because every market player has access to the same information and acts upon it without delay. In essence, you’d see no oscillation between supply and demand, meaning people couldn’t expect to consistently gain high profits from trading within an efficient market.

On the other hand, in an inefficient market , there's a lag in the reflection of available information in asset prices. Following the same scenario, if the market were inefficient, there would be a delay before that company’s stock price reflects the positive news. This delay presents an opportunity for savvy traders who've diligent enough to pay attention to the news, to buy the stock at its old, lower price, before the market adjusts and raises it.

The differentiation between these conditions primarily lies in how quickly and how accurately information gets incorporated in asset prices.

The Efficient Market Hypothesis (EMH) slots into this talk by stating that it's impossible to consistently achieve above-average profits by trading on publicly available information. Essentially, the EMH theorizes that markets are always efficient. It implies that 'beating the market' on a regular basis is nearly impossible.

While Determining Market Efficiency

Testing for market efficiency involves examining whether or not a particular market satisfies the conditions mentioned earlier. If asset prices adjust rapidly to new information and no investor can consistently achieve excess returns, then the market is deemed efficient. Conversely, if there are substantial price adjustments needed or a select few can gain profits consistently, then the market is deemed inefficient.

It's worth noting though, that while the EMH proposes markets are always efficient, the reality is that markets can fluctuate between stages of efficiency and inefficiency. These fluctuations often depend on a multitude of factors, such as accessibility to information, reaction speed of market players, and even psychological factors—elements that ensure the fascinating dynamism of economic markets.

Critiques of the Efficient Market Hypothesis

The Efficient Market Hypothesis paints an idealistic picture of financial markets, assuming they are perfectly efficient, and that prices always reflect all available information. However, this hypothesis has faced its share of critiques and controversies.

Bubbles and the Efficient Market Hypothesis

One of the most notable criticisms of EMH revolves around market bubbles. These are periods when asset prices increase dramatically and quickly, only to crash just as swiftly. Instances of stock market bubbles, housing bubbles, and dot-com bubbles have all raised questions about the validity of EMH. The dot-com bubble of the late 1990s – a period of enormous growth in internet-based companies – is a good example. During this time, stock prices soared drastically beyond what could have been justified by the future earnings prospects, contradicting the idea that prices always reflect all available information and the inherent value of an asset.

The financial crisis of 2007-2008 was another glaring example that challenged the EMH. It was marked by an unsustainable bubble in the U.S. housing market, and the subsequent crash affected financial markets globally. Both of these market anomalies suggested that market prices may not always accurately reflect underlying fundamentals.

Flash Crashes and the Efficient Market Hypothesis

In addition to market bubbles, the phenomenon of flash crashes also defies the predictions of EMH. Flash crashes refer to the sudden and dramatic plunge in stock prices in a very short time. One of the most significant flash crashes occurred on May 6, 2010, when the Dow Jones Industrial Average plunged more than 600 points within 5 minutes, only to recover a significant part of the losses very quickly. Such sudden and unexplained market swings seem at odds with the EMH, as they suggest that prices might not always reflect the true value, and can be influenced by an algorithms and high-frequency trading.

Irrational Investor Behavior

EMH also remains at odds with the concept of behavioral finance, which challenges the idea of investor rationality. Behavioral economists argue that investors' decisions are often influenced by emotional and cognitive biases, leading to irrational financial decisions that cause mispricing. For example, during times of market euphoria or panic, investors often succumb to herd mentality, buying or selling en masse, causing substantial mispricings. This notion contradicts the EMH's premise of rational investors, thereby questioning its relevance.

In conclusion, while the Efficient Market Hypothesis offers a simplified view of market functioning, the complexities of real-life financial markets, marked by bubbles, flash crashes, and irrational investor behavior, suggest a more nuanced reality.

EMH and Portfolio Theory

The integration of the Efficient Market Hypothesis with the Modern Portfolio theory is a crucial component in financial markets. In essence, the EMH assumes that all market participants have equal and immediate access to all pertinent information, thus negating the possibility of consistently outperforming the market, as all securities are always perfectly priced.

Implications for Modern Portfolio Theory

Modern Portfolio theory (MPT), on the other hand, focuses on maximizing portfolio expected return for a given amount of portfolio risk. If EMH holds true, it implies that a security's price reflects all available information, including the risk associated with it. Therefore, according to MPT, the best way to optimize a portfolio under EMH is to hold a diversified portfolio of all risky securities, colloquially known as the "market portfolio".

Asset Allocation

The combination of the EMH and MPT has significant implications for asset allocation. In an efficient market, diversifying your portfolio across broad asset classes should provide the optimal balance of risk and return. Chasing "undervalued" stocks or attempting to time the market are rendered futile exercises, since all available information is already incorporated accurately into asset prices. Therefore, the focus should be on establishing an appropriate asset mix that meets your financial goals and risk tolerance.

Risk Management

From a risk-management perspective, the EMH's incorporation within the Modern Portfolio Theory emphasizes the importance of diversification. Under this combination, the only way to reduce risk is through diversification, as all individual asset prices are fair and reflect all risk information. Investors cannot eliminate risk by picking undervalued securities, but can manage risk by holding a diversified portfolio which reduces unsystematic risk.

Overall, incorporating the Efficient Market Hypothesis into asset allocation and risk management strategies lends weight to a passive investing approach, where broad diversification, long-term holding, and a dispassionate, analytical outlook hold sway.

Implications of EMH on Corporate Finance

The Efficient Market Hypothesis (EMH) has far-reaching implications on corporate finance practices like capital budgeting, corporate governance, and financing decisions. Let's delve into each to understand better the role of EMH in corporate finance.

Capital Budgeting

The EMH suggests that all publicly available information is currently accounted for in the prices of securities. In the context of capital budgeting, this means companies cannot gain a competitive edge by timing their investments in the market or by choosing specific industries or sectors. Because all known information is presumed to be included in the current price, the future cash flows from any investment are unpredictable and should be treated as such in the budgeting process.

In effect, EMH encourages corporations to focus more on cost-effective and strategic investment planning rather than trying to outsmart the market. It underscores the need for incorporating risk analysis and scenario planning in investment decisions, rather than relying on market trends or predictions.

Corporate Governance

In the realm of corporate governance, EMH plays a crucial role. Directors and board members are expected to make decisions that are in the company's best interest. However, this can become a complex task given the supposed unpredictability of the market under EMH.

The board should ensure that the company adopts investment strategies that are not based on market forecasting or timing. It should instead look to achieve a diversified portfolio that is in alignment with the company's risk tolerance and strategic objectives. EMH encourages transparency and efficiency in internal practices since it contends that any lack of it can detrimentally affect a company's stock prices, considering all information is accountable in the market.

Financing Decisions

Finally, EMH's implications on financing decisions are profound. Since EMH proposes that stocks always trade at their fair value, it means that companies cannot rely on undervalued stocks or overvalued bonds for cheap financing. All securities are assumed to be priced correctly, reflecting all available, pertinent information.

As such, corporations need to develop their financing strategies based on interest rates, economic conditions, business opportunities, and their specific financial condition, rather than trying to beat the market. It discourages speculation in financing and encourages decisions based on sound financial principles and strategic goals.

In summary, the Efficient Market Hypothesis advocates for a systematic, rational approach to corporate finance. It highlights that financial success is not reliant on exploiting market inefficiencies, but is instead grounded in strategic planning, prudent decision-making, and efficient internal governance.

Implications of EMH in Behavioral Finance

Behavioral finance theories serve as a strong challenge to the Efficient Market Hypothesis (EMH). The central principle of these theories stipulate that market participants do not always act rationally, as the EMH presupposes, and are influenced by cognitive biases.

Influence of Cognitive Biases

A significant factor, cognitive bias, drastically diverges from the principles of the EMH. Investors, subject to cognitive biases, do not make investment decisions based solely on reliable information or act rationally. Instead, they're often swayed by their emotions, which can lead to irrational financial decision-making.

Overconfidence Bias

Overconfidence bias is a prime example of cognitive experience manipulating financial decisions. Investors, overestimating their knowledge or ability, might take unnecessary risks, driving market prices away from their true values. EMH, on the other hand, assumes all players behave rationally, neglecting the influence of human emotions.

Herd Mentality

The herd mentality describes the psychology behind the propensity for individuals to follow the masses rather than relying on their analysis or information. This bias can generate significant price changes that do not reflect accurate information about an asset's value, creating a discrepancy between the market price and intrinsic value.

Confirmation Bias

Confirmation bias refers to the inclination to seek out or interpret information that confirms existing beliefs. If prevalent, this bias could lead, over time, to a distorted market view, as investors selectively consume and comprehend information. EMH assumes that all relevant information is readily and equally accessible to all market players, something that does not align with confirmation bias.

Behavioral Finance vs EMH

In essence, behavioral finance acknowledges the often irrational, emotion-driven actions of investors, contradicting EMH's assumption of investors as rational actors. These biases can create inefficiencies in the market, distorting prices and leading them away from their true values. In such scenarios, the EMH's core principle – that securities are priced accurately, and any changes in value reflect changes in fundamental information – is challenged.

The Impact of Technology on EMH

The advent of technology, particularly machine learning and artificial intelligence, has significantly transformed financial markets. One such transformation is the rise of algorithmic trading. This technology-driven approach to trading involves pre-programmed instructions for placing trades at high speeds based on a range of variables including time, price, and volume.

The Advent of Algorithmic Trading

Algorithmic trading, also called algo-trading or black-box trading, theoretically supports the Efficient Market Hypothesis. Since EMH assumes that all information in a market is immediately exploited and prices are always fair, the high speed and efficiency of algorithmic trading seem to validate this hypothesis. Algorithmic trading allows for rapid execution of trades, making the most of available market information before it becomes widely known, thus efficiently adjusting the market price.

Information Efficiency and Technology

The role of information efficiency is crucial when discussing technological influence on EMH. Technology enhances the gathering, analyzing, and dissemination of financial information, leading to greater market efficiency. Market participants armed with sophisticated algorithmic tools have almost instant access to important information. This quick dissemination of information fosters a more easy adjustment of prices, supporting the concept of EMH as market anomalies are swiftly exploited.

However, technology also challenges the EMH. One of the foundational propositions of EMH is that all market participants have equal access to information. Yet, in the context of advanced technology and algorithmic trading, there's an informational asymmetry. Those who use sophisticated trading algorithms or have faster access to market information have an advantage over other participants. This can lead to the distortion of prices, challenging the idea of ‘fair’ prices proposed by EMH.

High Frequency Trading and EMH

Another aspect worth discussing is high frequency trading (HFT). HFT is a subset of algorithmic trading. Here, complex algorithms are used to trade financial instruments at incredibly high speeds. EMH might be challenged in scenarios where high frequency traders act on information before the broader market has a chance to react, potentially leading to artificial pricing.

Despite these challenges, technology's overall contribution to financial markets tends to lean towards increased efficiency. Even though apparent asymmetries exist, technology also democratizes access to information and trading capabilities, creating conditions for more individuals and entities to participate in financial markets and further contribute to their efficiency.

Relationship between EMH and Corporate Social Responsibility (CSR)

Despite being two entities that seem unrelated, the Efficient Market Hypothesis (EMH) and Corporate Social Responsibility (CSR) have distinct parallels that can influence a company's strategies and sustainability considerations.

EMH Implications on CSR

Beholden to EMH, a company's stock price showcases all available information, including its CSR initiatives. This suggests that every CSR act – beneficial or detrimental – reflects immediately on the company's stock value. Therefore, companies may actively strive to engage in proactive CSR strategies to maintain or increase their stock prices. This premise echoes the words of Milton Friedman, who stated, "There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits."

However, on the flip side, if a company’s CSR initiatives are purely profit-driven and the market perceives them as such, it might lead to a decrease in stock price, indicating EMH’s emphasis on the sincerity and effectiveness of CSR actions.

Influence of Market Efficiency on CSR Strategies

Market efficiency, which is central to EMH, plays a crucial role in shaping CSR strategies. Given that markets are efficient, companies cannot conceal their actual CSR activities and, therefore, must be upfront and transparent about their efforts. Information, after all, travels fast in efficient markets.

A transparent corporate environment can foster trust and respect among stakeholders, enhance corporate reputation, and ultimately, lead to a competitive advantage. Therefore, in efficient markets, companies might not just adopt CSR strategies that look good on paper but engage in genuine sustainable and ethical practices that add long-term value to the company.

Market Efficiency and Sustainability Considerations

Market efficiency also bears an impact on the sustainability considerations of a company. In light of EMH, firms cannot mislead investors over their long-term sustainability prospects. Therefore, companies might be incentivized to align their business operations and objectives with sustainable practices to satiate increasingly eco-conscious investors and stakeholders.

Efficient markets might punish firms that do not proactively tackle sustainability issues, which could eventually reflect in their stock prices. Similarly, companies stand to gain from stock-price appreciation if their sustainability efforts prove to be above expectations. In this manner, EMH can prompt companies to incorporate thorough sustainability practices into their management, supply chains, and overall operations.

In summary, EMH’s tenets compel firms to treat CSR and sustainability not as optional but as integral parts of their strategy. So, while EMH and CSR might appear as chalk and cheese, their symbiosis can have profound implications on the corporate world.

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efficient market hypothesis vs modern portfolio theory

Portfolio Theory and Market Efficiency

Modern Portfolio Theory (MPT) is a theory for how investors can construct portfolios of assets to achieve their goals in terms of desired returns and acceptable risk. Previous to the development of this theory, investors focused on choosing a collection of individual assets with the best stand-alone risk and return characteristics without regarding the relationship between these assets. Rather than focus on selecting individual securities, MPT considers portfolios of securities and examines the return and risk of these portfolios. The theory was introduced by Nobel-prize winner Harry Markowitz in 1952.

The MPT has been heavily criticized recently. We believe that this criticism is valid in many cases. Some of these criticisms stem from assumptions of the MPT which have been shown to not be generally valid. Some of these assumptions include:

Returns are normally distributed.

The market is efficient (we’ll discuss this issue later).

Costs, taxes, and transaction fees are ignored in the model.

Cumulatively the MPT critics argues that these assumptions are so fundamental to the mathematics of the model that the results are not meaningful since these assumptions are not valid. Despite these valid points of criticism, the model has introduced some key concepts into investing which we believe are valuable and contribute to the creation of a successful long-term portfolio. These concepts are: the value of diversification and the existence of an efficient frontier of investment portfolios. We’ll spend some time on these two concepts and leave it to the reader to do more research on MPT if he desires. Additionally, we’ll discuss another important theory, called Market Efficiency, and discuss its implications for the development of an investment strategy.

Diversification

Markowitz used a mathematical analysis of diversification to illustrate the value of making investment decisions based on portfolios rather than individual assets. The key insight was that the behavior of the assets in relation to one another will have an impact on the overall performance characteristics of the portfolio. Investors will typically judge the performance of a portfolio based on two measures: return and variance. The variance is a measure of the volatility of the returns of an asset. An asset with low variance will always deliver very similar returns while high variance will cause the returns to fluctuate greatly on a period-to-period basis. A general principle in investing is that you must sacrifice return to get low variance (and vice-versa). An example would be U.S. Treasuries which have lower mean returns than stocks but have much less variance.

For a portfolio, the mean return will simply be the weighted average of the returns of each of the component assets. Thus, if you have a portfolio of 50% bonds with a mean return of 4% and 50% stocks with a mean return of 8%, then the mean return of your portfolio will be 6%. However, the calculation of the variance of the portfolio includes terms which represent the correlation (or covariance) of the individual assets to one another.

Diversification can actually produce a portfolio with lower variance than the simple weighted average of the variances of each of the component assets. By diversification, we mean the construction of a portfolio from assets which are not perfectly correlated. With proper diversification, it is possible to reduce the variance (or risk) of a portfolio while not sacrificing the expected return.

To achieve this goal of reduced portfolio variance while not sacrificing mean return, you want select assets that have identical or similar mean returns but are uncorrelated or negatively correlated. With this approach, you can create an overall portfolio with similar return and lower variance than the best performing asset in your portfolio. This is the power of diversification.

In general, the concept of diversification is applied to two areas when investors construct portfolios. First, it is applied within asset classes. For instance, the investor may want to invest in large cap U.S. equities. Since the investor is not a professional, he may not be able to determine which individual stocks have the highest rates of return or lowest variances. They may all look the same from his standpoint. However, since the stocks represent companies in different business sectors, they will not all be highly correlated. Thus, he can choose a collection of these stocks and benefit from diversification. The collection will have the mean return of an average individual stock but will have a much lower variance thanks to the power of diversification. Thus, it is much less risky to hold the portfolio of S&P 500 stocks instead of just holding one stock.

Secondly, the concept of diversification is applied between asset classes. Now, let’s assume that our investor purchases all the S&P 500 stocks. We can think of this as one asset with a given expected mean return and variance. Now, he may choose to add another asset to the portfolio such as a U.S. Treasury bond. This new asset will also have an expected mean return and variance. As we mentioned before, U.S. Treasuries have historically had lower mean returns than the S&P 500 but have much less variance. Additionally, let’s assume that they are completely uncorrelated. Now, the investor will be giving up some mean return by adding the Treasuries to his portfolio but will definitely reduce his variance. In practice, it usually turns out that adding a small amount of an uncorrelated asset can lead to a decent sized reduction in variance while only causing a small decrease in expected return. This tradeoff may be acceptable to many investors.

To illustrate, let’s use an example taken from "The Intelligent Asset Allocator" by William Bernstein. There are two assets: stocks and bonds. In any period, the stocks are equally likely to return either +30% or -10% (a geometric mean return of 8%) while bonds are equally likely to return either +10% or 0% (a mean return of 5%). We can see by the volatility of the possible returns that the stocks have higher variance. The stocks and bonds are completely uncorrelated. Now, we want to compare portfolios consisting of various percentages of these stocks and bonds from 100% stocks to 100% bonds. Let’s plot these portfolios with mean return on the y-axis and standard deviation of returns on the x-axis.

efficient market hypothesis vs modern portfolio theory

Several points are illustrated by this graph. First, we see that starting with a portfolio of 100% stock and adding bond will reduce the variance of the portfolio. The loss of return is fairly small when bond is first added to the portfolio. Secondly, on the other side, adding stock to a portfolio of bonds will actually increase the return and reduce the variance until a decent amount of stock has been added. Another increasing point is to notice that the portfolio which consists of 50% stock and 50% bonds is not on the midpoint of a line connecting the 100% stock and 100% bond portfolios. It is actually above this line and to the left. This is the benefit of diversification. The same principle applies when we make more sophisticated assumptions concerning the distribution of returns for the assets within the portfolio. The important thing is that the assets not be fully correlated.

We think that diversification is a key principle that should be used by all long-term investors. It allows the investor to reduce the variance of his portfolio’s returns while hopefully not sacrificing too much in expected return.

Efficient Frontier

Our simple graph leads us to another concept in MPT: the existence of an Efficient Frontier. If we considered a set of asset classes and allowed investors to construct any possible portfolio consisting of these assets, then we could plot the return and standard deviation for each portfolio. There will be a set of portfolios which achieve the highest possible return for each level of standard deviation (or alternatively, the lowest standard deviation for each level of return). This set of portfolios forms the Efficient Frontier. This is where the investor wants his portfolio to be.

The chart below demonstrates the Efficient Frontier. The line represents the Efficient Frontier. All possible portfolios will lie on that line or below and to the right.

efficient market hypothesis vs modern portfolio theory

One major problem with the Efficient Frontier is that you cannot know which portfolios will lie on the efficient frontier before you invest. The set of portfolios on the Efficient Frontier must be calculated with either historical results or estimates of the returns, variances and covariances of all asset classes. Unfortunately, returns, variances and covariances of asset classes will change over time. The idea is still a useful concept and you can use your own estimates or historical data to find portfolio which you believe will be near the Efficient Frontier. That is the best that we can hope for when

Market Efficiency

There is an ongoing debate between academics and industry insiders about the ability of individuals to pick stocks whose returns will consistently beat the average of whatever segment of the market in which they invest. These debates center around the idea of Market Efficiency. The theory of Market Efficiency states that all information about a company or asset will be built into its price and the future movement of the stock is basically a random walk that can’t be predicted. If a positive movement could be predicted then the market would drive up the price and any possible gain would be crushed. Academics have produced many studies where they show that many high-performing mutual fund managers have benefited from luck much more than skill. The industry insiders (especially mutual fund managers) argue that this theory is incorrect. They argue that their analysis and investing techniques can put them at an advantage over the average investor. Thus, they think that consistent winning stock pickers exist.

There are two main problems that face the individual investor. First, does you believe that the market is really completely efficient? If no, then there should be an opportunity to beat the market. However, how do you identify the stock pickers who will be successful in the future?

Based on our experience and research, we believe that the market is not completely efficient. Although most of the hard data in the debate favors the Efficient Market theory, we believe that there is a small set of investment professionals who have the ability to beat the market over the long-term. However, from the investor’s standpoint, it is very difficult to identify these managers. Academics have performed many studies where they seek to find characteristics of successful stock pickers (so they can predict who will be successful in the future). However, they have failed to devise a method for identifying successful managers in advance. We don’t think that the individual investor will be successful at identifying these managers.

Mutual Funds and the Efficient Market

To compound the problem that it is very difficult to identify a successful manager, if you invest in actively traded mutual funds, you will be fighting an uphill battle to just match the performance of the market. The problem is that mutual funds incur costs that cause their net returns to lag the market. The current mutual fund industry is so massive that it can’t be expected to beat the market – it is the market! Thus, it makes intuitive sense that the mutual funds would lag the market by the amount of their expenses. In fact, typically 80+% of all mutual funds will lag the market (or relevant sector) returns on an annual post-cost basis. When you increase the length of the period over which you compare mutual funds to the market returns, the percentage of mutual funds which under-perform increases to over 90+% for a 5 year period.

Actively managed mutual funds create expenses for investors in various ways. Let’s describe some of them.

Management fees and marketing expenses : These expenses which are generally captured in the expense ratio. These expenses will directly reduce the your return.

Commissions : Fees charged to the fund when they make trades of the underlying assets in their portfolio.

Bid-ask spreads : Whenever trades are executed, the fund must pay more for the asset than they could sell it for. This spread is essentially lost by the investor.

Market impacts : Buying an asset will cause its price to increase. Thus, the total cost of buying an asset will turn out to be larger than the current price times the number of shares desired.

Studies have been conducted that show that mutual funds tend to lag the market by a little bit more than their total expenses. In fact, the mutual funds with the highest expense ratios tend to have the worst pre-expense returns. That’s amazing! Even with more money to spend on research, they perform the worst.

The story actually gets worse. Actively managed mutual funds have other tax problems that we explain elsewhere on this website.

These ideas about Market Efficiency and the problems of active mutual funds point the investor towards developing a strategy which involves investments in low-cost index funds or exchange-traded funds (ETFs).

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  • Quantitative Analysis

Modern Portfolio Theory: Why It's Still Hip

Skylar Clarine is a fact-checker and expert in personal finance with a range of experience including veterinary technology and film studies.

efficient market hypothesis vs modern portfolio theory

If you were to craft the perfect investment, you would probably want its attributes to include high returns and low risk.

The reality, of course, is that this kind of investment is next to impossible to find. Not surprisingly, people spend a lot of time developing methods and strategies that come close to the "perfect investment." But none have been as popular as modern portfolio theory (MPT).

Here, we look at the basic ideas behind MPT, its pros and cons, and how it should factor into your portfolio management.

Key Takeaways

  • Modern portfolio theory (MPT) argues that it's possible to design an ideal portfolio that will provide the investor maximum returns by taking on the optimal amount of risk.
  • MPT was developed by economist Harry Markowitz in the 1950s; his theories surround the importance of portfolios, risk, diversification, and the connections between different kinds of securities.
  • In particular, MPT advocates diversification of securities and asset classes or the benefits of not putting all your eggs in one basket.
  • MPT says stocks face both systematic risk—market risks such as interest rates and recessions—as well as unsystematic risk—issues that are specific to each stock, such as management changes or poor sales.
  • Proper diversification of a portfolio can't prevent systematic risk, but it can dampen, if not eliminate, unsystematic risk.

One of the most important and influential economic theories dealing with finance and investment, MPT was developed by Harry Markowitz and published under the title "Portfolio Selection" in the  Journal of Finance  in 1952.

The theory is based on Markowitz's hypothesis that it is possible for investors to design an optimal portfolio to maximize returns by taking on a quantifiable amount of risk. Essentially, investors can reduce risk through diversification using a quantitative method.

Modern portfolio theory says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification —chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, or not putting all of your eggs in one basket.

For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return . Each stock has its own standard deviation from the mean , which modern portfolio theory calls "risk."

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks, provided the risks of the various stocks are not directly related. Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn't rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio.

In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's nest egg . 

Markowitz, along with Merton H. Miller and William F. Sharpe, changed the way people invested; for their life's work, the three shared the 1990 Nobel Prize in Economic Sciences.

Modern portfolio theory states that the risk for individual stock returns has two components:

Systematic Risk : These are market risks that cannot be diversified away. Interest rates, recessions , and wars are examples of systematic risks.

Unsystematic Risk : Also known as "specific risk," this risk is specific to individual stocks, such as a change in management or a decline in operations. This kind of risk can be diversified away as you increase the number of stocks in your portfolio (see the figure below). It represents the component of a stock's return that is not correlated with general market moves.

For a well-diversified portfolio, the risk—or average deviation from the mean—of each stock contributes little to portfolio risk. Instead, it is the difference—or covariance —between individual stocks' levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks.

Now that we understand the benefits of diversification, the question of how to identify the best level of diversification arises. Enter the efficient frontier .

For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line is the efficient frontier. The figure below shows the efficient frontier for just two stocks—a high risk/high return technology stock (like Google) and a low risk/low return consumer stock (like Coca-Cola).

Any portfolio that lies on the upper part of the curve is efficient: It gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.

Modern portfolio theory takes this idea even further. It suggests that combining a stock portfolio that sits on the efficient frontier with a risk-free asset , the purchase of which is funded by borrowing, can actually increase returns beyond the efficient frontier. In other words, if you were to borrow to acquire a risk-free stock, then the remaining stock portfolio could have a riskier profile and, therefore, a higher return than you might otherwise choose.

When a portfolio is well-balanced, the individual risk of each stock has little impact on overall portfolio risk; rather, it's the difference between each stock's level of risk that influences the overall portfolio risk.

Modern portfolio theory has had a marked impact on how investors perceive risk, return, and portfolio management . The theory demonstrates that portfolio diversification can reduce investment risk. In fact, modern money managers routinely follow its precepts. Passive investing also incorporates MPT as investors choose index funds that are low cost and well-diversified. Losses in any individual stock are not material enough to damage performance due to the diversification, and the success and prevalence of passive investing is an indication of the ubiquity of modern portfolio theory.

As ubiquitous as MPT might be, it still has some shortcomings in the real world. For starters, it often requires investors to rethink notions of risk. Sometimes it demands that the investor take on a perceived risky investment ( futures , for example) in order to reduce overall risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated portfolio management techniques.

Furthermore, MPT assumes that it is possible to select stocks whose individual performance is independent of other investments in the portfolio. But market historians have shown that there are no such instruments. In times of market stress, seemingly independent investments do act as though they are related.

Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio returns , but finding a truly risk-free asset is another matter. Government-backed bonds are presumed to be risk-free, but, in reality, they are not. Securities such as gilts and U.S. Treasury bonds are free of default risk , but expectations of higher inflation and interest rate changes can both affect their value.

Then there is the question of the number of stocks required for diversification. How many is enough? Mutual funds can contain dozens and dozens of stocks. Investment guru William J. Bernstein says that even 100 stocks are not enough to diversify away the unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber in their book Modern Portfolio Theory And Investment Analysis (1981), conclude that you would come very close to achieving optimal diversity after adding the 20th stock.

The gist of MPT is that the market is hard to beat and that the people who beat the market are those who take on above-average risk. It is also implied that these risk-takers will get their comeuppance when markets turn down.

Then again, investors such as Warren Buffett remind us that portfolio theory is just that—theory. At the end of the day, a portfolio's success rests on the investor's skills and the time that they devote to it. Sometimes it is better to pick a small number of out-of-favor investments and wait for the market to turn in your favor than to rely on market averages alone.

Harry Markowitz. " Portfolio Selection ."

The Nobel Prize. " The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990 ."

William J. Bernstein. " The 15-Stock Diversification Myth ."

Edwin J. Elton and Martin Jay Gruber. " Modern Portfolio Theory and Investment Analysis ." Wiley, 1981.

efficient market hypothesis vs modern portfolio theory

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Saturday 9 February 2013

Efficient market hypothesis vs modern portfolio theory, 55 comments:.

efficient market hypothesis vs modern portfolio theory

Isn't the EMH always viewed in as "risk adjusted returns" being unpredictable.

efficient market hypothesis vs modern portfolio theory

Samuelson's 1965 paper which was used by Fama in stating the EMH was titled "Proof that properly anticipated prices fluctuate randomly". Returns are being calculated on the basis of prices and dividends. Thus, if prices cannot be forecasted how can you forecast returns?

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efficient market hypothesis vs modern portfolio theory

EMH requires that future prices cannot be predicted based on past prices. It says nothing about future returns and past returns, which is the relevant variable for MPT. In fact, MPT requires EMH in some sense because the same arguments that lead to EMH also lead to things like the efficient frontier and the tangency portfolio.

Yes weak-form EMH does say that, but returns are being calculated based on prices and dividends. So if you need prices to calculate returns and prices are not forecastable then how can you forecast returns? Even if dividends can be forecasted (which I do not say they can) then you still have the other part of the equation as unforecastable. The only shared assumptions between the EMH and the MPT are: 1. Agents are aiming at maximizing utility 2. Agents are risk-neutral and rational The above two are probably the most used assumptions in economic modelling. Still, as I have said in the text the point here is not to argue the models' assumptions.

Is it not possible for something to follow a random walk, but at the same time for investors to have a rational view as to its expected volatility? So that's EMH and MMT both applying.

It depends on what you mean "a rational view". The EMH postulates that nothing of the past can be used to forecast the future. If you use past prices (or whatever) to estimate something of the future then you do not adhere to the EMH. EMH is basically stating that there can be no forecast based on past data thus any view based on that will be erroneous.

Before one questions decades of empirical work done by some brilliant economists, a dose of humility is suggested. If you read Samuelson's paper, on page 2 he says, 'This martingale property of zero expected capital gain will then be replaced by the slightly more general case of a constant mean percentage gain per unit time'. Additionally, I'd recommend reading the substantial amount of writing that Fama has done on the subject, among many others, since 1970. There is far more nuance to the EMH than typically presumed.

First of all, this is not an arrogant post. I am merely stating something that I feel people have not been discussing over the years. Second, the Samuelson paper is much distinct from the Fama one. Samuelson just said that "properly anticipated prices fluctuate randomly"; it was Fama who took it one step further and suggested that stock prices move randomly. By reading what Fama has written on the subject one should not forget to throw a look on Shiller, Lo and MacKinley and Grossman and Stiglitz. I cannot profess to have full knowledge of the subject (and as you have seen I have not commented on whether I believe the MPT or the EMH to be correct or not) but, as said before, this is merely something that many have been avoiding through the years.

The tone of your post isn't arrogant but the intellectual presumptuousness is. You are claiming that very smart people who have spent their lives studying this field have made an elementary error in basic assumptions. As far as critics of EMH, I have a lot of respect for many of them who make valid criticisms, which exist. No model of reality is perfect and any model is made better by allowing new data and analysis to inform and refine it. But as far as reading critics, it makes no sense to do so until you understand the original argument. EMH, as stated by Fama, does most certainly not say that prices are a complete random walk. Per his paper on EMH, written in 1970, p. 387 footnote 5, 'The random walk model does not say, however, that past information is of no value in assessing distributions of returns. Indeed since return distributions are assumed to be stationary through time, past returns are the best source of such information. The random walk model does say, however that the sequence (or the order) of the past returns is of no consequence in assessing distributions of future returns.' They do assume that returns are i.i.d., which is empirically false, but that is widely acknowledged today, and computing power now allows empiricists to bootstrap past distributions rather than assuming the simple two parameter normal model. Additionally, most of the anomalies pointed out in the subsequent literature (including the Fama-French Size/Value factors) are included in any test of EMH. There are other anomalies (momentum, low beta, which was actually a Fischer Black finding, etc.), but each of those anomalies is risky. Indeed, the volatility of the anomalies is generally as high, or higher than that of the market premium. But back to the point: EMH and MPT are not contradictory whatsoever, because EMH does not state past prices provide no valuable insight into future prices. As Fama points out, there is value in the data, and thus MPT is simply using that data, assuming that the distribution of returns of various assets is stable over time, and optimizing the mix of assets to achieve an 'efficient' portfolio. Now there are plenty of arguments against that assumption, but it does not mean that MPT and EMH are in conflict. It just provides a long term model of the relationship between assets and returns, but one based only on past experience. Again, what we see is that deviations from the model often provide opportunities to make excess returns, but the riskiness of those excess returns can be quite high. The value premium underperformed for nearly a decade, the momentum anomaly is currently underperforming, etc. So none of these strategies is an arbitrage strategy that provide risk free excess returns. So is EMH wrong? Most certainly yes. But do we have anything that does better than it? There aren't really any compelling empirical options. Sure, behavioralists tell some really good stories and have some good examples that we should keep in mind. However, they don't provide a coherent testable model. Indeed, I think behavioralists would do themselves a favor by acknowledging that they may have solid explanations for some of the anomalies that have been found, but not a full blown asset pricing model. To be fair, I think EMH advocates can be just as frustrating in their defense. There is room for a constructive dialogue between both groups, but very few on each side are willing to admit that. I think that has led to this horribly incorrect view on what is meant by EMH and its implications. If there is one area where Fama has failed, it is in his articulation to a wider audience the basic implications. Perhaps that is for the next generation.

No I am not claiming that and I doubt that there is anything of intellectual pompousness from my side in this discussion. I am merely claiming that the two theories cannot coexist (in their original form as also stated in the article) unless they are modified. And this has not been addressed thus far that is why I am mentioning it. Copy from your quote: "The random walk model does say, however that the sequence (or the order) of the past returns is of no consequence in assessing distributions of future returns." I am not arguing against i.i.d here, I have not even mentioned that in the article. Yet, when you are saying that the sequence of past returns is of no consequence in assessing distributions of future returns what exactly do you mean if not that past prices are not a good predictor of future prices? If the past distribution is of no use for the future distribution then why should I use it in my estimations/forecast? The random walk model depends on the independence of the variables which, if applied to markets, is the same as saying that past values are not a good predictor of future ones; something which the MPT relies on when it estimates the beta. And isn't bootstrapping essentially creating random distributions from data? I can agree with Fama (and you subsequently) on one thing: the reason why there has not been a total dismissal of the EMH is that no other theory can work in general, just in specific cases. Yet, this does not mean neither that the EMH holds and neither that no other theory will ever be found. Your two final paragraphs are the ones which I agree more with: we need dialogue and yet we need to be open to new ideas and criticism. You are right that no other theory thus far has worked in general and not just specifics no matter what its supporters might claim. I agree with the EMH that markets usually know; but this does not mean that they are either efficient or random.

Well considering you missed the 'not' in my quote of Fama, that is the whole point of what I was saying. Fama does NOT dismiss past returns as a whole as being informative. I would HIGHLY recommend reading his 1970 paper on EMH as it walks through all of this and covers the actual hypothesis he proposes. Critics tend to create caricatures of the EMH which are quite easy to knock down. So generally they are arguing about completely different things because by efficient, Fama does not mean markets know all or are perfect, just that it is systematically very difficult to beat the market, plain and simple. There is no conflict between EMH and MPT. There are plenty of problems with both, but no conflict. To assume that countless practitioners have missed such a basic incongruence is presumptuous, regardless of whether you believe so or not.

Apologies as I didn't read carefully but you selectively picked my fama quote. The first half says yes past returns are valuable, but their order is not necessarily so.

I did selectively use the Fama quote but the part I used could stand on its own and be correct. Past returns could perhaps be valuable: yet, if their order is not I practically have zero use for them. To say that they are "of no consequence" means exactly that. (to be honest I thought you were referring to the original 1965 paper not the 1970 one.) It is not presumptuous, think of it this way: in physics Aristotelian notions were dominating thought up until new discoveries were made; and many a clever physicist would swear by them. It is not that I believe practitioners were not clever or they have no idea of what is going on. I just feel that some times what is harder to see is what is more obvious.

I'll address your first point below, but I'd have to argue that comparing your very dubious claim EMH and MPT aren't compatible to the transition from Aristotelian physics to Galileo and Newton is quite, ummm, immodest. I would think one would want to have a much firmer grasp of both before claiming the start of a revolution.

and bootstrapping is taking the realized historical distribution and sampling randomly from that, rather than assuming normal (which Fama admits that he did because computers weren't capable of doing this back then, so he discounts his results accordingly). also, there are techniques which allow non random sampling of a bootstrapped distribution, i.e., try to mimic previous market regimes when correlations increased and the sample wasn't i.i.d. there is a lot of very interesting stuff going on in the empirical world right now that has updated this theory. i think Fama himself has been fairly willing to update his priors as time has gone on as well.

Sampling randomly essentially means it is creating something that does not exist in the data doesn't it? In essence, using past data using and not using past data. Past prices, in the MPT are not sampled randomly to get the beta; they are used as they are. That is my point.

So back to your earlier point, Fama was explicitly referencing Random Walk, which is only a special case of EMH. The looser form just assumes 'Fair Game' dynamics. But that is besides the point. EMH simply says that current prices reflect all information and is appropriately pricing future joint distribution of returns. In other words, using all past data, it is very difficult to systematically earn excess returns (relative to the amount of risk taken). To cover MPT and betas, I don't really know what you mean. EMH needs to be tested using an asset pricing model. This involves betas. Both EMH and MPT assumes the distribution of returns of different assets is stable over time, i.e., expected returns and correlations are the same over long periods of time. MPT simply maximizes expected returns for a given level of risk by using the past historical returns and optimizing the mix of assets, assuming that expected returns and correlations are stable. MPT does NOT say that you can earn excess returns by analyzing past returns. By assuming that the past distribution of returns will be the same as the future (and MPT does not care about sequence, unless by sequence you are implying the cross section, aka, correlations, which both MPT and EMH care about), you can create an efficient (not the same meaning as in EMH, but that is traditional terminology) portfolio. But MPT only cares about the long term averages and correlations and not the actual sequence. So again, I don't see that you are making any point. EMH and MPT are complementary, not contradictory.

First of all, the Aristotelian-Newtonian transition was just an analogy to indicate that very clever people may believe in something wrong for a very long time. Yet, I am not suggesting that the EMH is wrong; my view is that it's a bit unrealistic. In fair game dynamics you mean perfect information, etc right? As already said in the article, the original form of the EMH, i.e. the Fama (1965) article, specifically mentions the the random walk, which is just putting the "properly anticipated prices fluctuate randomly" notion into stock market context. Prices reflect all information about the past, present and future, thus I cannot earn excess returns if I use them correct? Yet, I need to use them in order to find my optimal portfolio, with regards to risk and return as the MPT states. If this portfolio, according to the EMH will fluctuate randomly in the future, then I will have nothing but a very vague idea of the risk and returns of it. Not excess returns mind you! I wouldn't even have any idea of the risk-reward relationship thus I wouldn't be able to find my optimal portfolio. One of the basic tenets of the MPT is the beta right which we can say is the relationship between the stock and the index. Yet, I base the beta estimations on previous data, since I have no other options right? This is just for my risk-return relationship and my optimal portfolio not excess returns or anything of the like. But if past prices are just random, then my estimates about risk and return will be just wrong. I would have the same probability of selecting a low risk-return portfolio by throwing darts on a board. The EMH tests using betas found that there is a correlation between betas and future betas; this is part of what led people to rethink the EMH since it cannot be random and non-random at the same time. Once again, excess returns have nothing to do with my argument. It is the risk-return relationship which cannot be known if prices fluctuate randomly, thus ruling out the probability of finding my optimal portfolio.

So first, I just want to reclarify the debate: you claim that EMH is contradictory to MPT because EMH claims past prices are random. Since MPT uses past prices as inputs to create an 'efficient' (not in EMH sense) portfolio, MPT and EMH aren't compatible. Is that right? So onto your points by paragraph: 1) Of course EMH is technically wrong and certainly unrealistic. It is a model and all models are by definition false. They are meant to provide a useful framework to think about how things work. 2) Fair game means that information is accessible to all investors and in a sense, 'fair'. You cannot game the system by systematically knowing information before everyone else, like early earnings releases. 3) Let's clarify things here. EMH does not rely the Random Walk as its core tenet. I'm presuming the article you are referring to is "The Behavior of Stock Market Prices". Even within that (I confess to not having read all 73 pages but I have read a lot of his recent work, including his 1970 review and most of his book, Foundations of Finance), he admits that strict RW is not a realistic assumption. But that is besides the point (right now at least). Even within a RW, you can allow for a drift term, i.e., a higher level of returns for stocks rather than bonds. He calls this the 'Intrinsic-value-random-walk' market. The random walk is the error term in the equation you use to test EMH. Any test of EMH is a joint test of both market efficiency and a pricing model. Now let's be very careful about what we call 'excess returns'. In EMH literature, this is returns above and beyond the level of risk taken, so you need to adjust for volatility. For MPT, excess returns might sometimes mean anything earned above the risk free rate, unadjusted for risk. Also, EMH says that the best predictor of the future price distribution of a security is its past distribution. It does not say it is unpredictable, just that the price of the security in the present reflects that information (for example, you might pay a higher multiple for cashflows with a higher level of certainty and that security may exhibit less volatility since its payouts may be less subject to bad events). So EMH does not say the portfolio will fluctuate randomly. So what is the point of MPT, in light of the insights of EMH? MPT attempts to build a model that explains the movement of asset prices. Let's say the model is successful in explaining 70% of the movement of prices (which is high!), that implies that the other 30% of movement is either random or unexplained. However, using that 70% that we can explain, we try to build a portfolio of uncorrelated assets that gives us a certain level of return. In doing so, we hope the randomness or the unexplained variance offset eachother and bring down the vol of the portfolio.

4) There are estimation errors in the parameters, including beta, and beta doesn't have to be the stock index, it can be whatever you choose to regress against returns (oversimplification but multi-factors and state variable regressions can be run as well). Ideally, if you are adding enough assets into a portfolio, your covariance matrix will end up having a significant impact on the optimal portfolio and there is error in those estimates as well. EMH isn't telling you that you can't earn future returns by optimizing your portfolio using MPT; indeed, it says the opposite! There is large uncertainty in estimating future returns. Don't take large concentrated bets because there is a large degree of randomness involved in the outcome and it resembles a fair chance dynamic (zero risk premium, i.e., idiosyncratic risk). Instead, take systematic risk, which is, in theory, rewarded (i.e., equity risk). Investors willing to accept these systematic risks (volatility) should be able to generate premiums for doing so. The last couple sentences are the theory behind why these things happen, not justification for EMH or MPT. 5) So, just to reiterate, EMH does not say prices move randomly. It allows for a drift term, and that drift term is likely related to the level of risk of the security. It just says that predicting the movement around that drift term is very very difficult to do in a systematic fashion. Hopefully I've done a better job at explaining my position

Yes, that was my argument in the post. 1. There are models which depict reality better than others; EMH is not in that category. 2. We agree on definitions then, although the strong-form EMH basically states that even inside information does not matter. 3.Yes that is the paper I was referring to and it is indeed long and tiring. Using drift does not really prove a point. All it does is allowing for the model to start at a higher value, e.g. like you said, higher returns for stocks than for bonds although this does not always hold. It just says e.g. the stock market will fluctuate randomly above 2,000 points. When I mentioned excess returns I meant the EMH definition (as you define it). Yet, even if you test the EMH definition, you are in fact somehow misusing it. You wouldn't be able to control for the risk if you had nowhere to depend on, given that prices move randomly. Does it not really say that the portfolio will fluctuate randomly? Think of it this way: if the stock price reflects all past information (and future and inside information if we use the strong form) then all that is left which can alter my valuation is future information. Yet, this information is random by definition (not just in stock market, but in general). Thus, the future value of the portfolio will depend on future information which you do not have at the moment of estimating; then future prices will move randomly if information is random. This makes my estimation rather useless. I agree with your points on the MPT, though. Yet, the MPT was not build on the EMH and that is for sure. Fist of all, Markowitz published his paper in 1952, 13 years before Fama and Samuelson; no matter how clever, Markowitz could not build something on a notion that had not been developed in his time. 4. I agree on the beta dynamics, but I disagree on the perception of the EMH. If it does say that then the EMH is contradicting itself. And large, concentrated bets are something against which the MPT advices. 5. A drift term does not mean that the model is not random. Have a look at this: http://people.duke.edu/~rnau/411rand.htm Let's make the argument simpler: do you agree that the EMH comments that prices reflect all information available? (I would even let the strong form out and forget about inside information). If yes, then do you also agree that only future information can move prices?

I'm not going to sit here and try to continually knock down the straw man you have created. Go read ch. 5 of fama's foundations of finance, titled efficient capital markets, found for free on his website. prices do not move randomly. whenever you test market efficiency, it is a joint test of both an asset pricing model and market efficiency. saying the stock price reflects all available information does not mean that we cannot use past data to understand how future prices may move. it just means that the market, based on past data, is accurately pricing the stock. the past distribution of returns is likely to resemble the future distribution of returns. your final point: yes that is true. EMH says that prices reflect all information. but that DOES NOT mean that the future price distribution of securities is unknown and inestimable. It explicitly states that the past distribution is the best estimate for the future distribution. "the appropriate current prices are determined by some model of market equilibrium - that is, by a model that determines what equilibrium current prices should be on the basis of characteristics of the joint distribution of prices at t." i will not respond to any follow ups that clearly ignore what is publicly available information. it is your responsibility to actually read what is claimed by EMH if you believe you are going to refute it and its congruence with MPT.

Just a simple note: if you agree on my last point then you have created an ideological wall around your beliefs. If prices can only move by future information and future information is random then by construction, prices are going to be random as well. Unknown is one thing and random is another. Random does not meet unknown, yet it does mean unforcastable (up to a point). Nothing further to add. And your quote clearly states "current prices" not future ones... Interestingly, from what I have read on the subject, the only clear conclusion is that whenever the theory is proven non-functioning people just tend to say "yes, but we can change it and it might work ergo it works"

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efficient market hypothesis vs modern portfolio theory

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IMAGES

  1. Efficient market hypothesis: A unique market perspective

    efficient market hypothesis vs modern portfolio theory

  2. Efficient Market Hypothesis

    efficient market hypothesis vs modern portfolio theory

  3. What Is The Efficient Market Hypothesis (EMH) & How Does It Work

    efficient market hypothesis vs modern portfolio theory

  4. Efficient Market Hypothesis

    efficient market hypothesis vs modern portfolio theory

  5. Efficient Market Hypothesis (EMH): Definition and Critique

    efficient market hypothesis vs modern portfolio theory

  6. Efficient Market Hypothesis Or EMH As Investment Evaluation Outline

    efficient market hypothesis vs modern portfolio theory

VIDEO

  1. Security Analysis Important topis in one video #1

  2. Efficient market hypothesis

  3. THE EFFICIENT MARKET THEORY PART 2 FUNDAMENTAL OF INVESTMENTS

  4. The Efficient Market Hypothesis explained#youtubeshorts #shorts #viral #india #business

  5. Investments

  6. Efficient Market Hypothesis (EMH)

COMMENTS

  1. Modern Portfolio Theory vs. Behavioral Finance

    Market Efficiency . The idea that financial markets are efficient is one of the core tenets of modern portfolio theory. This concept, championed in the efficient market hypothesis, suggests that ...

  2. Does Modern Portfolio Theory align with EMH?

    The Efficient Market Hypothesis (EMH) states that you cannot beat the market on a risk-adjusted basis by looking at past prices. You can certainly earn higher returns than the market if you take on more risk (by leveraging, for example). Modern Portfolio Theory allows you to construct portfolios that are efficient.

  3. The Efficient Market Hypothesis, the Financial Analysts Journal, and

    The efficient market hypothesis (EMH) that developed from Fama's work (Fama 1970) for the first time challenged that presumption. ... showed that the EMH is an implication of general equilibrium theory in a capital market dominated by informed and rational agents. ... in the new world of high-frequency trading, portfolio managers need to ...

  4. Modern Portfolio Theory: Definition, Examples, & Limitations

    At the heart of modern portfolio theory is the concept of diversification. Diversification involves spreading investments across a range of ... and used it as the starting point for such fundamental financial concepts as the efficient market hypothesis (EMH) and the capital asset pricing model (CAPM). Without MPT, their work might have taken ...

  5. Efficient Market Hypothesis (EMH): Definition and Critique

    Aspirin Count Theory: A market theory that states stock prices and aspirin production are inversely related. The Aspirin count theory is a lagging indicator and actually hasn't been formally ...

  6. Modern Portfolio Theory: What MPT Is and How Investors Use It

    Modern Portfolio Theory - MPT: Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of ...

  7. What Is the Efficient Market Hypothesis?

    Getty. The efficient market hypothesis argues that current stock prices reflect all existing available information, making them fairly valued as they are presently. Given these assumptions ...

  8. PDF The Efficient Market Hypothesis and its Critics

    A generation ago, the efficient market hypothesis was widely accepted by academic financial economists; for example, see Eugene Fama's (1970) influential survey article, "Efficient Capital Markets." It was generally believed that securities markets were extremely efficient in reflecting information about individual stocks and

  9. PDF Modern Portfolio Theory and The Efficient Markets Hypothesis: How Well

    portfolio's ability to adequately provide for the subject couple's financial needs in retirement. Results of the model portfolio were compared to other popular investment alternatives. Using generally-accepted rules-of-thumb in financial planning, the model portfolio was found to have provided an adequate retirement income for the subject ...

  10. Efficient-market hypothesis

    The efficient-market hypothesis (EMH) ... 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 ...

  11. The Weak, Strong, and Semi-Strong Efficient Market Hypotheses

    The weak form of the theory is the most lenient and concedes that there are circumstance when fundamental analysis can help investors find value. The strong form of the theory is the least lenient ...

  12. What Is the Efficient-Market Hypothesis? Overview & Criticisms

    The efficient-market hypothesis remains a cornerstone of financial theory and has had a profound influence on investment strategies, portfolio management, and the understanding of financial markets. Although its three forms provide an accepted framework for thinking about market efficiency, the debate about its validity continues.

  13. Modern Portfolio Theory and The Efficient Markets Hypothesis: How Well

    The core point of MPT is that high return comes with high risk. 1 Capturing the many basic points of MPT, Eugene Fama (1965) and Paul A. Samuelson (1965) developed the efficient market hypothesis ...

  14. PDF EFFICIENT PORTFOLIOS VERSUS EFFICIENT MARKET

    One of the most important developments in modern investment theory is the effi­ cient market hypothesis. Market efficiency refers to the speed with which informa­ tion is rationally absorbed. Thus, statements about market efficiency are always made with respect to a particular set of information. Three information sets with

  15. Portfolio Theory is Inconsistent with the Efficient Market Hypothesis

    If modern capital theory does not require market efficiency, its logical progenitor, portfolio theory, actually contradicts the efficient market hypothesis. Even if an investor has absolute confidence in a new piece of information, the relevant security will still be subject to specific developments as surprising to the investor as they are to ...

  16. Efficiency Market Hypothesis (EMH): Understanding the Pivotal Theory in

    The integration of the Efficient Market Hypothesis with the Modern Portfolio theory is a crucial component in financial markets. In essence, the EMH assumes that all market participants have equal and immediate access to all pertinent information, thus negating the possibility of consistently outperforming the market, as all securities are ...

  17. The Capital Asset Pricing Model and the Efficient Markets Hypothesis

    Abstract. The Capital Asset Pricing Model and the Efficient Markets Hypothesis, two central aspects of the theorizing of contemporary financial economics, have been subject to a barrage of specific criticisms but remain resilient and indeed centerpieces of the theorizing and highly influential policy advice of leading contemporary financial economists.

  18. What Is Modern Portfolio Theory?

    Modern portfolio theory helps investors minimize market risk while maximizing return. It starts with two fundamental assumptions: You cannot view assets in your portfolio in isolation. Instead ...

  19. Efficient Market Hypothesis: Is the Stock Market Efficient?

    The Efficient Market Hypothesis (EMH) is an investment theory stating that share prices reflect all information and consistent alpha generation is impossible. more Informationally Efficient Market ...

  20. Warren Buffett & Charlie Munger: Efficient Market Theory

    Warren Buffett and Charlie Munger discuss the efficient market theory and its popularity at universities. From the 1998 Berkshire Hathaway annual meeting.Top...

  21. Portfolio Theory and Market Efficiency

    Modern Portfolio Theory (MPT) is a theory for how investors can construct portfolios of assets to achieve their goals in terms of desired returns and acceptable risk. ... The theory of Market Efficiency states that all information about a company or asset will be built into its price and the future movement of the stock is basically a random ...

  22. Modern Portfolio Theory: Why It's Still Hip

    Key Takeaways. Modern portfolio theory (MPT) argues that it's possible to design an ideal portfolio that will provide the investor maximum returns by taking on the optimal amount of risk. MPT was ...

  23. Efficient Market Hypothesis vs Modern Portfolio Theory

    Lately, I have had some time available to have a look at what appears to be the most influential theories of the 20th century (regarding stock markets that is): the Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMH).