Are markets efficient?
The question of whether markets are efficient has been debated for decades and there is no consensus. However, I think the debate and conclusion is best summed up by a famous story.
A finance professor and his student were walking across campus when they spotted a $20 bill on the ground. The professor advised, “Don’t bother picking that up. If it was real, someone would’ve picked it up already.” The student picks it up anyways and buys herself a beer.
There are not a lot of $20 bills laying on the ground, but they are found from time to time. That’s the short answer. The longer answer is below.
What does market efficiency mean?
The term efficiency is used to connote several different ideas, but the most common one is a concept formalized into the Efficient Markets Hypothesis (EMH) by Eugene Fama, who won a Nobel prize for his work on the subject. The theory basically says that markets allocate capital best and thus value assets best (or “efficiently”). There are 3 forms of the theory:
- Weak Form: all historical information is priced into an asset’s price.
- Semi-Strong Form: all historical and public information is incorporated into an asset’s price.
- Strong Form: all historical, public, and non-public information is Incorporated into an asset’s price.
Below are some examples of situations where each form does not hold up.
Strong Form claim: all historical, public, and non-public information is Incorporated into an asset’s price.
Strong Form problems:
- Prices often have material and sustained moves when private information is publicized.
- Prices often move on earnings announcements or press releases.
- The uncovering of scandals or fraud impacts prices.
- I do not know anyone that subscribes to the strong form of the EMH.
Semi-Strong Form claim: all historical and public information is incorporated into an asset’s price.
Semi-Strong Form problems:
- Arbitrage opportunities exist fairly frequently. Although not all are actionable due to constraints and costs, enough are.
- Closed-end funds can trade at extreme premiums and discounts to their underlying NAV.
- We have seen public companies trading for less than the value of their stakes in other public companies.
Weak Form claim: all historical information is priced into an asset’s price.
Weak Form problems:
- Momentum as a risk factor has been shown to offer a return premium.
- Flash crashes and flash rallies have extreme mean reverting tendencies.
There are many more examples of market inefficiency, but few would have been robust enough to categorically prove markets are inefficient (and stand up to every possible logical critique).
So, are markets efficient?
Beyond poking holes in the idea of market efficiency, the above examples represent opportunities for active managers to outperform. Yet, there is plenty of data that indicates markets are difficult to beat on a consistent basis. This implies (but does not prove) that markets are at least somewhat “efficient.” If markets were generally inefficient, it would seem that investors would beat the markets more easily, frequently, and consistently.
So what can we conclude? That markets are not always efficient, but are probably efficient at least some of the time. This is a very unsatisfying answer, but that is okay because it is unclear whether market efficiency even matters to investors. I’ll explain why in an upcoming post.
Additional thoughts on market efficiency
Even if markets are generally efficient, efficiency seems non-existent during certain times (ie. when rationality gets thrown out the window during bubbles and panics) and in specific asset classes (where there are constraints to arbitrage, complexity, due diligence costs, transaction costs, or anything else that makes it difficult to invest easily). So my usual answer to the original question is that markets are generally efficient, but there are episodes and pockets of inefficiency.