efficient market hypothesis vs modern portfolio theory

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

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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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Modern Portfolio Theory

• First Online: 27 July 2016

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• James Ming Chen 3  

Part of the book series: Quantitative Perspectives on Behavioral Economics and Finance ((QPBEF))

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Portfolio theory may be the most fecund intellectual export from quantitative finance to other sciences. Social sciences outside the strictly financial domain have applied portfolio theory to subjects as diverse as regional development, 1 social psychology, 2 and information retrieval. 3 Proper understanding of portfolio theory and its place in finance and cognate sciences begins with a return to the origins of modern portfolio theory. For “the end of all our exploring/Will be to arrive where we started/And know the place for the first time.” 4

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See generally, e.g., Paul H. Cootner, The Random Character of Stock Market Prices (1964); Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work , 25 J. Fin. 383–417 (1970); Eugene F. Fama, Efficient Capital Markets II , 46 J. Fin. 1575–1617 (1991); Eugene F. Fama, The Behavior of Stock Market Prices , 38 J. Bus. 34–105 (1965); Lawrence H. Summers, Does the Stock Market Rationally Reflect Fundamental Values? , 41 J. Fin. 591–601 (1986); Eugene F. Fama & Kenneth R. French, The Cross-Section of Expected Stock Returns , 47 J. Fin. 427–465, 427–429 (1992).

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Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2410 (2014); see also Schleicher v. Wendt, 618 F.3d 679, 685 (7th Cir. 2010) (recognizing the fact that “the … price [of a stock] may be inaccurate does not detract from the fact that false statements affect it, and cause loss,” in violation of Basic, Inc. v. Levinson ’s fraud on the market rule).

Amgen , 133 S. Ct. at 1192; accord Halliburton , 134 S. Ct. at 2411.

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See generally Frederick C. Dunbar & Dana Heller, Fraud on the Market Meets Behavioral Finance , 31 Del. J. Corp. L. 455–531, 463–464 (2006).

See Paul A. Samuelson, Proof That Properly Anticipated Prices Fluctuate Randomly , 6 Indus. Mgmt. Rev. 41–49 (1965)

The Supreme Court’s “fraud on the market” theory “relied upon the ‘semi-strong’ version” of the efficient markets hypothesis. Halliburton Co. v. Erica P. John Fund Inc., 134 S. Ct. 2398, 2420 (2014) (Thomas, J., concurring in the judgment) (citing Lynn A. Stout, The Mechanisms of Market Inefficiency: An Introduction to the New Finance , 28 J. Corp. L. 635–669, 640 & n.24 (2003); Fama, Efficient Capital Markets: A Review of Theory and Empirical Work , supra note 55, at 388).

See Andrew W. Lo & Jasmina Hasanhodzic, The Evolution of Technical Analysis: Financial Prediction from Babylonian Tablets to Bloomberg Terminals 150 (2010).

See generally Sitabhra Sinha, Arnab Chatterjee, Anirban Chakraborti & Bikas K. Chakrabarti, Econophysics: An Introduction (2011). The interaction between finance and physics has come a long way since Louis Jean-Baptiste Bachelier’s path-breaking books such as Théorie de la Spéculation (1900), Calcul des Probabilités (1912), and Le Jeu, la Chance, et le Hasard (1914). See James Owen Weatherall, The Physics of Wall Street: A Brief History of Predicting the Unpredictable 10–11 (2013) (reporting that Bachelier’s thesis at La Sorbonne was poorly received because he was trying to apply mathematics to a field with which mathematicians of his time were unfamiliar).

See Luciano Zunino, Aurelio Fernandez Bariviera, M. Belén Guercio, Lisana B. Martinez & Osvaldo A. Rosso, On the Efficiency of Sovereign Bond Markets , 391 Physica A 4342–4349 (2012); Aurelio Fernandez Bariviera, Luciano Zunino, M. Belén Guercio, Lisana B. Martinez & Osvaldo A. Rosso, Revisiting the European Sovereign Bonds with a Permutation-Information-Theory Approach , 86 Eur. Phys. J. B 509 (2014).

See Eugene F. Fama & Kenneth R. French, Luck Versus Skill in the Cross-Section of Mutual Fund Returns , 65 J. Fin. 1915–1947 (2010).

See, e.g., Jonathan Brogaard, Terrence Hendershott & Ryan Riordan, High-Frequency Trading and Price Discovery , 27 Rev. Fin. Stud. 2267–2306 (2014); Terrence Hendershott, Charles M. Jones & Albert J. Menkveld, Does Algorithmic Trading Improve Liquidity? , 66 J. Fin. 1–33 (2011); Albert J. Menkveld, High Frequency Trading and the New Market Makers , 16 J. Fin. Mkts. 712–740 (2013); Martin L. Scholtus, Dick J.C. Van Dijk & Bart Frijns, Speed, Algorithmic Trading, and Market Quality Around Macroeconomic News Announcements , 38 J. Banking & Fin. 89–105 (2014).

See Eugene F. Fama & Kenneth R. French, Permanent and Temporary Components of Stock Prices , 96 J. Pol. Econ. 246–273 (1988).

Benjamin Graham & David L. Dodd, Security Analysis 452 (1st ed. 1934); see also Benjamin Graham, The Intelligent Investor (1st ed. 1949).

John Y. Campbell & Robert F. Shiller, Stock Prices, Earnings, and Expected Dividends , 43 J. Fin. 661–676, 666 (1988).

Robert J. Shiller, Irrational Exuberance 256 n.19 (3d ed. 2015) (quoting Samuelson). For empirical evidence supporting this dictum, see Randolph Cohen, Christopher Polk & Tuomo Vuolteenaho, The Value Spread , 58 J. Fin. 609–642 (2003); Jeeman Jung & Robert J. Shiller, Samuelson's Dictum and the Stock Market , 43 Econ. Inquiry 221–228 (2005); Tuomo Vuolteenaho, What Drives Firm-Level Stock Return? , 57 J. Fin. 233–264 (2002).

See William F. Sharpe, The Arithmetic of Active Management , 47:1 Fin. Analysts J. 7–9, 7 (Jan./Feb. 1991).

See Edwin J. Elton & Martin J. Gruber, Investments and Portfolio Performance 382–383 (2011); Steven Roman, Portfolio Management and the Capital Asset Pricing Model 53–67 (2004).

See André F. Perold, The Capital Asset Pricing Model , 18 J. Econ. Persp. 3–24, 10–12 (2004).

See James Tobin, Liquidity Preference as Behavior Towards Risk , 67 Rev. Econ. Stud. 65–86 (1958); cf. Winston W. Chang, Daniel Hamberg & Junichi Hirata, Liquidity Preference as Behavior Toward Risk Is a Demand for Short-Term Securities—Not Money , 73 Am. Econ. Rev. 420–427 (1983).

See David Cass & Joseph E. Stiglitz, The Structure of Investor Preferences and Asset Returns, and Separability in Portfolio Allocation , 2 J. Econ. Theory 122–160 (1970); Robert C. Merton, An Analytic Derivation of the Efficient Portfolio Frontier , 7 J. Fin. & Quant. Analysis 1851–1872 (1972); Stephen A. Ross, Mutual Fund Separation and Financial Theory—The Separating Distributions , 17 J. Econ. Theory 254–286 (1978).

See sources cited supra note 55.

See Sharpe, Arithmetic of Active Management , supra note 78, at 7–8.

See Philip H. Dybvig & Jonathan E. Ingersoll, Jr., Mean-Variance Theory in Complete Markets , 55 J. Bus. 233–251 (1982). On the notion of complete markets, where economic conditions permit the emergence of a set of prices that allow aggregate supplies of every commodity in the economy to satisfy aggregate demand, see generally Kenneth J. Arrow & Gérard Debreu, Existence of an Equilibrium for a Competitive Economy , 22 Econometrica 265–290 (1954).

See generally Paul A. Samuelson, General Proof That Diversification Pays , 2 J. Fin. & Quant. Analysis 1–13 (1967).

See Lawrence A. Cunningham, From Random Walks to Chaotic Rashes: The Linear Genealogy of the Efficient Capital Markets Hypothesis , 62 Geo. Wash. L. Rev. 546–608, 568–570 (1994).

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Chen, J.M. (2016). Modern Portfolio Theory. In: Postmodern Portfolio Theory. Quantitative Perspectives on Behavioral Economics and Finance. Palgrave Macmillan, New York. https://doi.org/10.1057/978-1-137-54464-3_2

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Efficient Market Hypothesis (EMH)

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on July 12, 2023

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Table of contents, efficient market hypothesis (emh) overview.

The Efficient Market Hypothesis (EMH) is a theory that suggests financial markets are efficient and incorporate all available information into asset prices.

According to the EMH, it is impossible to consistently outperform the market by employing strategies such as technical analysis or fundamental analysis.

The hypothesis argues that since all relevant information is already reflected in stock prices, it is not possible to gain an advantage and generate abnormal returns through stock picking or market timing.

The EMH comes in three forms: weak, semi-strong, and strong, each representing different levels of market efficiency.

While the EMH has faced criticisms and challenges, it remains a prominent theory in finance that has significant implications for investors and market participants.

Types of Efficient Market Hypothesis

The Efficient Market Hypothesis can be categorized into the following:

Weak Form EMH

The weak form of EMH posits that all past market prices and data are fully reflected in current stock prices.

Therefore, technical analysis methods, which rely on historical data, are deemed useless as they cannot provide investors with a competitive edge. However, this form doesn't deny the potential value of fundamental analysis.

Semi-strong Form EMH

The semi-strong form of EMH extends beyond historical prices and suggests that all publicly available information is instantly priced into the market.

This includes financial statements, news releases, economic indicators, and other public disclosures. Therefore, neither technical analysis nor fundamental analysis can yield superior returns consistently.

Strong Form EMH

The most extreme version of EMH, the strong form, asserts that all information, both public and private, is fully reflected in stock prices.

Even insiders with privileged information cannot consistently achieve higher-than-average market returns. This form, however, is widely criticized as it conflicts with securities regulations that prohibit insider trading .

Assumptions of the Efficient Market Hypothesis

Three fundamental assumptions underpin the Efficient Market Hypothesis.

All Investors Have Access to All Publicly Available Information

This assumption holds that the dissemination of information is perfect and instantaneous. All market participants receive all relevant news and data about a security or market simultaneously, and no investor has privileged access to information.

All Investors Have a Rational Expectation

In EMH, it is assumed that investors collectively have a rational expectation about future market movements. This means that they will act in a way that maximizes their profits based on available information, and their collective actions will cause securities' prices to adjust appropriately.

Investors React Instantly to New Information

In an efficient market, investors instantaneously incorporate new information into their investment decisions. This immediate response to news and data leads to swift adjustments in securities' prices, rendering it impossible to "beat the market."

Implications of the Efficient Market Hypothesis

The EMH has several implications across different areas of finance.

Implications for Individual Investors

For individual investors, EMH suggests that "beating the market" consistently is virtually impossible. Instead, investors are advised to invest in a well-diversified portfolio that mirrors the market, such as index funds.

Implications for Portfolio Managers

For portfolio managers , EMH implies that active management strategies are unlikely to outperform passive strategies consistently. It discourages the pursuit of " undervalued " stocks or timing the market.

Implications for Corporate Finance

In corporate finance, EMH implies that a company's stock is always fairly priced, meaning it should be indifferent between issuing debt and equity . It also suggests that stock splits , dividends , and other financial decisions have no impact on a company's value.

Implications for Government Regulation

For regulators , EMH supports policies that promote transparency and information dissemination. It also justifies the prohibition of insider trading.

Criticisms and Controversies Surrounding the Efficient Market Hypothesis

Despite its widespread acceptance, the EMH has attracted significant criticism and controversy.

Behavioral Finance and the Challenge to EMH

Behavioral finance argues against the notion of investor rationality assumed by EMH. It suggests that cognitive biases often lead to irrational decisions, resulting in mispriced securities.

Examples include overconfidence, anchoring, loss aversion, and herd mentality, all of which can lead to market anomalies.

Market Anomalies and Inefficiencies

EMH struggles to explain various market anomalies and inefficiencies. For instance, the "January effect," where stocks tend to perform better in January, contradicts the EMH.

Similarly, the "momentum effect" suggests that stocks that have performed well recently tend to continue performing well, which also challenges EMH.

Financial Crises and the Question of Market Efficiency

The Global Financial Crisis of 2008 raised serious questions about market efficiency. The catastrophic market failure suggested that markets might not always price securities accurately, casting doubt on the validity of EMH.

Empirical Evidence of the Efficient Market Hypothesis

Empirical evidence on the EMH is mixed, with some studies supporting the hypothesis and others refuting it.

Evidence Supporting EMH

Several studies have found that professional fund managers, on average, do not outperform the market after accounting for fees and expenses.

This finding supports the semi-strong form of EMH. Similarly, numerous studies have shown that stock prices tend to follow a random walk, supporting the weak form of EMH.

Evidence Against EMH

Conversely, other studies have documented persistent market anomalies that contradict EMH.

The previously mentioned January and momentum effects are examples of such anomalies. Moreover, the occurrence of financial bubbles and crashes provides strong evidence against the strong form of EMH.

Efficient Market Hypothesis in Modern Finance

Despite criticisms, the EMH continues to shape modern finance in profound ways.

EMH and the Rise of Passive Investing

The EMH has been a driving force behind the rise of passive investing. If markets are efficient and all information is already priced into securities, then active management cannot consistently outperform the market.

As a result, many investors have turned to passive strategies, such as index funds and ETFs .

Impact of Technology on Market Efficiency

Advances in technology have significantly improved the speed and efficiency of information dissemination, arguably making markets more efficient. High-frequency trading and algorithmic trading are now commonplace, further reducing the possibility of beating the market.

Future of EMH in Light of Evolving Financial Markets

While the debate over market efficiency continues, the growing influence of machine learning and artificial intelligence in finance could further challenge the EMH.

These technologies have the potential to identify and exploit subtle patterns and relationships that human investors might miss, potentially leading to market inefficiencies.

The Efficient Market Hypothesis is a crucial financial theory positing that all available information is reflected in market prices, making it impossible to consistently outperform the market. It manifests in three forms, each with distinct implications.

The weak form asserts that all historical market information is accounted for in current prices, suggesting technical analysis is futile.

The semi-strong form extends this to all publicly available information, rendering both technical and fundamental analysis ineffective.

The strongest form includes even insider information, making all efforts to beat the market futile. EMH's implications are profound, affecting individual investors, portfolio managers, corporate finance decisions, and government regulations.

Despite criticisms and evidence of market inefficiencies, EMH remains a cornerstone of modern finance, shaping investment strategies and financial policies.

Efficient Market Hypothesis (EMH) FAQs

What is the efficient market hypothesis (emh), and why is it important.

The Efficient Market Hypothesis (EMH) is a theory suggesting that financial markets are perfectly efficient, meaning that all securities are fairly priced as their prices reflect all available public information. It's important because it forms the basis for many investment strategies and regulatory policies.

What are the three forms of the Efficient Market Hypothesis (EMH)?

The three forms of the EMH are the weak form, semi-strong form, and strong form. The weak form suggests that all past market prices are reflected in current prices. The semi-strong form posits that all publicly available information is instantly priced into the market. The strong form asserts that all information, both public and private, is fully reflected in stock prices.

How does the Efficient Market Hypothesis (EMH) impact individual investors and portfolio managers?

According to the EMH, consistently outperforming the market is virtually impossible because all available information is already factored into the prices of securities. Therefore, it suggests that individual investors and portfolio managers should focus on creating well-diversified portfolios that mirror the market rather than trying to beat the market.

What are some criticisms of the Efficient Market Hypothesis (EMH)?

Criticisms of the EMH often come from behavioral finance, which argues that cognitive biases can lead investors to make irrational decisions, resulting in mispriced securities. Additionally, the EMH has difficulty explaining certain market anomalies, such as the "January effect" or the "momentum effect." The occurrence of financial crises also raises questions about the validity of EMH.

How does the Efficient Market Hypothesis (EMH) influence modern finance and its future?

Despite criticisms, the EMH has profoundly shaped modern finance. It has driven the rise of passive investing and influenced the development of many financial regulations. With advances in technology, the speed and efficiency of information dissemination have increased, arguably making markets more efficient. Looking forward, the growing influence of artificial intelligence and machine learning could further challenge the EMH.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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Efficient Market Hypothesis (EMH) Tenets and Variations

Problems of emh, qualifying the emh, increasing market efficiency, the bottom line, efficient market hypothesis: is the stock market efficient.

An important debate among investors is whether the stock market is efficient—that is, whether it reflects all the information made available to market participants at any given time. The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally.

Financial theories are subjective. In other words, there are no proven laws in finance. Instead, ideas try to explain how the market works. Here, we take a look at where the efficient market hypothesis has fallen short in terms of explaining the stock market's behavior. While it may be easy to see a number of deficiencies in the theory, it's important to explore its relevance in the modern investing environment.

Key Takeaways

• The Efficient Market Hypothesis assumes all stocks trade at their fair value.
• The weak tenet implies stock prices reflect all available information, the semi-strong implies stock prices are factored into all publicly available information, and the strong tenet implies all information is already factored into the stock prices.
• The theory assumes it would be impossible to outperform the market and that all investors interpret available information the same way.
• Although most decisions are still made by humans, the use of computers to analyze information may be making the theory more relevant.

There are three tenets to the efficient market hypothesis: the weak, the semi-strong, and the strong.

The weak make the assumption that current stock prices reflect all available information. It goes further to say past performance is irrelevant to what the future holds for the stock. Therefore, it assumes that technical analysis can't be used to achieve returns.

The semi-strong form of the theory contends stock prices are factored into all information that is publicly available. Therefore, investors can't use fundamental analysis to beat the market and make significant gains.

In the strong form of the theory, all information—both public and private—are already factored into the stock prices. So it assumes no one has an advantage to the information available, whether that's someone on the inside or out. Therefore, it implies the market is perfect, and making excessive profits from the market is next to impossible.

The EMH was developed from economist Eugene Fama's Ph.D. dissertation in the 1960s.

While it may sound great, this theory is not without criticism. Other schools of thought, such as Alphanomics , argue that markets can be inefficient.

First, the efficient market hypothesis assumes all investors perceive all available information in precisely the same manner. The different methods for analyzing and valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock's fair market value . Therefore, one argument against the EMH points out that since investors value stocks differently, it is impossible to determine what a stock should be worth in an efficient market.

Proponents of the EMH conclude investors may profit from investing in a low-cost, passive portfolio.

Secondly, no single investor is ever able to attain greater profitability than another with the same amount of invested funds under the efficient market hypothesis. Since they both have the same information, they can only achieve identical returns. But consider the wide range of investment returns attained by the entire universe of investors, investment funds , and so forth. If no investor had any clear advantage over another, would there be a range of yearly returns in the mutual fund industry, from significant losses to 50% profits or more? According to the EMH, if one investor is profitable, it means every investor is profitable. But this is far from true.

Thirdly (and closely related to the second point), under the efficient market hypothesis, no investor should ever be able to beat the market or the average annual returns that all investors and funds are able to achieve using their best efforts. This would naturally imply, as many market experts often maintain, the absolute best investment strategy is simply to place all of one's investment funds into an index fund. This would increase or decrease according to the overall level of corporate profitability or losses. But there are many investors who have consistently beaten the market. Warren Buffett is one of those who's managed to outpace the averages year after year.

Eugene Fama never imagined that his efficient market would be 100% efficient all the time. That would be impossible, as it takes time for stock prices to respond to new information. The efficient hypothesis, however, doesn't give a strict definition of how much time prices need to revert to fair value . Moreover, under an efficient market, random events are entirely acceptable, but will always be ironed out as prices revert to the norm.

But it's important to ask whether EMH undermines itself by allowing random occurrences or environmental eventualities. There is no doubt that such eventualities must be considered under market efficiency but, by definition, true efficiency accounts for those factors immediately. In other words, prices should respond nearly instantaneously with the release of new information that can be expected to affect a stock's investment characteristics. So, if the EMH allows for inefficiencies, it may have to admit that absolute market efficiency is impossible.

Although it's relatively easy to pour cold water on the efficient market hypothesis, its relevance may actually be growing. With the rise of computerized systems to analyze stock investments, trades, and corporations, investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods. Given the right power and speed, some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution.

Despite the increasing use of computers, most decision-making is still done by human beings and is therefore subject to human error. Even at an institutional level, the use of analytical machines is anything but universal. While the success of stock market investing is based mostly on the skill of individual or institutional investors, people will continually search for the surefire method of achieving greater returns than the market averages.

It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to occur, all of these things must happen:

• Universal access to high-speed and advanced systems of pricing analysis.
• A universally accepted analysis system of pricing stocks.
• An absolute absence of human emotion in investment decision-making.
• The willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants.

It is hard to imagine even one of these criteria of market efficiency ever being met.

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Saturday 9 February 2013

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

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

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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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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