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What is the Efficient Market Hypothesis? And What Does it Mean for You?

Navigating the financial markets can often feel like you’re in a labyrinth, with news outlets, analysts, and every ‘guru’ on the internet vying for your attention, each one painting a picture of the market landscape teeming with endless opportunities for extraordinary gains (or horrific losses). But there’s an easy way for investors (whether you’re focused on retirement or not) to cut through the noise.

The financial markets absolutely are monstrously complex things. Pretty much everything that you can imagine goes into the markets – and drives security prices. And we can largely ignore all of it because of something called the Efficient Market Hypothesis.

What is the Efficient Market Hypothesis and Why It Matters to You

You may have heard of the Efficient Market Hypothesis (often abbreviated as the EMH) before. It’s one of those things that a lot of people are vaguely aware of (and trotted out when they want to sound smart), but it’s also pretty widely misunderstood – often especially by the people who think they do understand it.

At its core, the Efficient Market Hypothesis, developed by Eugene Fama at the University of Chicago (in a shockingly readable paper), says that financial markets are beset with such ferocious competition that their prices reflect all available information at any given point in time. In other words, there are so many people constantly buying and selling that everything that everyone knows – facts about the company, what’s going on in the economy, how people feel about both the company and economy, what people think will happen next, what they think other people think will happen next (I’m watching you Vizzini), and everything else – goes into a security’s price. And this means that, unless you know something different than literally everyone else in the world, it’s all but impossible to consistently beat the market.

It’s also, to use a slightly technical term, the null hypothesis of finance. The EMH is the baseline of finance. Essentially, if someone thinks the markets are not efficient, the burden of proof is on them to prove it. And if it’s not true, it should be pretty easy to disprove – you just need to show how to consistently beat the market. But we’re still waiting on that.

Deciphering the Efficient Market Hypothesis

A good place to start picking apart the idea of market efficiency is by thinking about what “all available information” really means. First up, it doesn’t mean that markets are perfect (if that’s even a meaningful concept – though we’ll come back to this).

It does mean that market prices are our best guess of what a company is actually worth based on what we currently know. But we also know that our best guess isn’t quite right. Or put more directly, we know that it’s wrong. Problem is, we don’t know if the price is wrong because it’s too high, or too low. You can think of a security’s price as the midpoint of the market’s expectations.

But let’s back up a second and think about how market prices are actually set. There’s no entity determining the value of a security. The market price is really just the last price that a security traded for. It’s just the most recent time that a buyer and seller matched. But let’s think about this a bit more.

Prices are based on what people are willing to pay for a security – all of the market participants in the world trading billions of dollars trying to be right.

And they really care about getting it right because they have their own money on the line.

They are building these wildly complex models trying to predict that “true” value of a security (or just going off a hunch), and then they are basing their trading on the results. If they think that Amazon is overpriced, they’ll start selling. And if enough people agree, then the price of Amazon will start coming down. If they think that Amazon is under priced, then they’ll start buying – driving the price up.

This self correcting process is both the magic of the markets, and the mechanism for how markets can be efficient. But so far we’re only talking about a single point in time. How do prices move?

Markets Move on Updated Information

Once the markets arrive at a price, something needs to happen for that price to move. If a stock’s price incorporates all of the available information, there’s no reason for it to change unless there’s new information.

But, well, that’s constantly happening. It’s called news.

We are constantly bombarded with new information. Both new factual information, but also how that new information makes us feel, and what that new information means for our expectations about the future. And it doesn’t even have to be new specific information that sets off this process. It could just be our interpretation of something that we already knew changes. Given how fast the world changes the question isn’t why the markets move, but rather why they don’t move even more.

There’s a catch here though – since prices incorporate expectations about the future, it’s not just whether something good or bad happens that determines if a security goes up or down. It’s how that new information squares with what the market expected to happen. If something good happened, but it wasn’t quite as good as everyone expected it to be, the price will drop. On the other hand, if something bad happened, but it wasn’t quite as disastrous as expected, the price will go up.

And this is really common to see. Just look at what happens when companies release their earnings. They are always accompanied by some sort of analyst’s estimate of what the earnings were expected to be. This is both to give us some sort of scale, but also so we can tell how the company did relative to expectations – whether the stock price should go up or down.

This means that to reliably beat the market you either need to have access to information that others don’t (which is insider trading, and I think that’s the SEC on the phone for you), or you need to be able to need to not just be able to predict the future, you need to be able to do it better than everyone else.

All Interesting Models Are Wrong

The EMH is either incredibly elegant or messy depending on your perspective. But it’s important to remember that it is just a model.

And every interesting model is wrong.

They don’t perfectly describe reality – if they did, they would be reality, and they would be so complex that they would cease to be useful. There are constantly people picking at the edges of the efficient market hypothesis trying to find ways of reliably beating the markets (such as, well, most of the finance industry and a pretty big chink of the academic finance world as well).

We can also point to specific managers, like Peter Lynch, who was either astronomically lucky, or he truly was able to beat the market. You can slice and dice his numbers any way you would like, but he clearly was adding value for his investors (though even he couldn’t pick successors who could beat the market – which is a lot more like the challenge you and I face trying to beat the market).

There are probably a huge number of market inefficiencies out there (though not every price discrepancy is an inefficiency). But we mentioned that the market is self correcting – when investors find something out there that let’s them make money, they will pile in – to the point they can’t make any more money.

By exploiting the market inefficiency they make the market more efficient. But to prove the Efficient Market Hypothesis wrong, or even to start poking holes in it, you need to be able to find a way to beat the market that isn’t self correcting – or at least a way to find ways to beat the market.

And that hasn’t shown up yet.

How Should You Invest?

So where does this leave us? And more specifically, what does the market being efficient mean for how you should be investing for retirement?

Well, the simple answer is that you shouldn’t be trying to beat the market. You should let the market work for you.

This means keeping things simple. Start with the market portfolio (and adjust based on how you’re different from the average investor), and use index funds. If you can’t beat the market, you might as well get the market.

But more importantly, build your portfolio as part of your broader retirement income plan. For most of us, our investment portfolio will play a big part in how we pay for retirement. But it’s not the whole plan. And you need to make sure that your investments mesh with the other pieces to create a plan that works for our retirement income style and situation.

Investing – and retirement planning – is about the long term. Markets tend to go up – that’s why we invest. But they also go down. And we need to build our portfolios to be able to deal with those drops. A well designed portfolio, in a well designed retirement plan, will let you ignore all of the short term noise and focus on enjoying the retirement you deserve.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.

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