What do we think of the Efficient Market Hypothesis?

Should investors try to pick stocks?

When we talk about the “price signal” that we get from looking at the current market valuation of a stock or other asset, what exactly does that mean? Certainly we can deduce that the asset is “worth” that particular amount because it could currently be sold for that amount. But what if we are not selling the asset right away, and instead holding it to be sold at some future date?

Since as investors we may well hold many stocks for fairly long periods of time, the present moment’s “unrealized” gain or loss on a stock may never actually be realized at that current price point. As the expectations of future profits and cash flows change for a share, the price will fluctuate (and perhaps, go up over time). But does the current price always capture the best possible assessment of current value based on publicly available information?

One answer comes from the Efficient Market Hypothesis, which says, well, yes.

As Kate Raworth explains in her book Doughnut Economics (p. 60):

According to Eugene Fama’s influential “efficient-market hypothesis” of 1970, the price of financial assets always fully reflects all relevant information.

Similarly, Investopedia notes:

The efficient market hypothesis (EMH) or theory states that share prices reflect all the information available.

So this view essentially holds that enough people have pored over the financial statements, looked into the economic trends, and projected into the future, and their combined trading activity has helped ‘discover’ a ‘correct’ price.

One trend that may have been driven by this hypothesis is the move to investing in ETFs. Composed of multiple assets like mutual funds but tradable like stocks, ETFs allow users to buy funds that track entire indices, the way State Street’s SPY and Vanguard’s VOO both track the S&P 500. This enables investors to play the broad market instead of taking specific bets on certain companies.

But don’t stock pickers thrive on picking specific companies or sectors rather than the whole market? Many do, yes, but the data suggests that many would achieve investing results that lag the S&P 500 since fund managers overall consistently struggle to beat that index.

There are definitely times when an investor might think they have an insight into a company and want to take a position in its shares. But is it actually worth it? That’s still up for debate.

But as widespread belief has declined that individuals can find insights and make picks that will outperform the market, index fund ETFs are increasingly the largest position for many investors. Over time, this is causing a certain amount of automation of the market, as illustrated by the clamor by funds to acquire shares of a company when they enter the S&P 500, causing a short-lived feedback loop of buying. Long term effects of this trend on the stock market are hard to predict.

[Disclosure: I buy and sell stocks, ETFs, and other investments.]