Warren Buffett said, “I’d be a bum on the street with a tin cup if the markets were always efficient”. The Efficient Market Hypothesis (EMH) has drew flak from all corners when the concept was first introduced. The academics believe that the market is relatively efficient such that there is little or no chance for anyone to profit from it. The common analogy was that, if you see a $100 bill on the street, you should not pick it up. If it is real, someone would have picked it up. Is the market really efficient in that case? I put forth 6 points to question the hypothesis.
#1 – Perfect knowledge is impossible
EMH suggests perfect information. Humans guard secrets. No one has a complete information on something. Try it on your company CEO, I bet he don’t even have an idea what you are doing. If a company does not have complete knowledge about herself, what makes you think an outsider/investor has complete knowledge about the company. CEOs cannot even predict future earnings despite making the decisions for the company and managing the operations. What makes an outsider/investor having a good prediction on the future growth? Perfect knowledge is like the perfect competition concept in Economics. It is an ideal state that only happens in Utopia.
#2 – Subjectivity in interpretations
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Even when you have first hand information that no others have, the way you interpret it may be different from another person. The subjective interpretations of information would also cause the market to be ‘mispriced’.
#3 – Wrong assumption on rationality
Worst of all, the theory assumes that humans make rational financial decisions in the market. Related to the point above, if the people who had first hand information but acted irrationally, prices will diverge from ‘norm’ or the mean. Many behavioural finance studies have shown that humans have the tendency to be risk averse when it comes to gains and risk seeking when it comes to losses. Below is the example of prospect theory to illicit the irrationality in financial decision (taken from Investopedia:
“You have $1,000 and you must pick one of the following choices:
- Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0.
Choice B: You have a 100% chance of gaining $500.
- You have $2,000 and you must pick one of the following choices:
Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0.
Choice B: You have a 100% chance of losing $500.
If the subjects had answered logically, they would pick either “A” or “B” in both situations. (People choosing “B” would be more risk adverse than those choosing “A”). However, the results of this study showed that an overwhelming majority of people chose “B” for question 1 and “A” for question 2. The implication is that people are willing to settle for a reasonable level of gains (even if they have a reasonable chance of earning more), but are willing to engage in risk-seeking behaviors where they can limit their losses. In other words, losses are weighted more heavily than an equivalent amount of gains.”
#4 – Booms and Busts occur
If the market is efficient, we would not have booms and busts. This is because the prices cannot be so far away from true value. People with good knowledge and first hand information would be able to bring the price back to normal. But we have seen Long Term Capital Management failed to do that using mean reversion techniques. The spreads can widening and eventually bankrupted the hedge fund. They could not borrow enough to fight against the masses.