The Efficient Markets Hypothesis

Richard A. Stanford

The theory of Rational Expectations underlies the Efficient Markets Hypothesis. According to this hypothesis, in equilibrium the risk-adjusted return on all investments should be equal, i.e., the return one may expect from a share of stock should exactly equal the return that can be had on any other financial instrument with similar risk characteristics. If any single financial instrument exhibits a higher risk-adjusted rate of return than others, investors can be expected to attempt to purchase that instrument, thereby causing its price to rise and its rate of return to fall. This suggests that it is not possible to systematically beat the market by picking a stock which will outperform the market.

This idea, which is reminiscent of some early thought about the workability of perfect competition, comes close to assuming a conclusion. Perfection of competition includes full and instantaneous market knowledge of any changing condition. But if everyone can be instantly aware of a changed market condition, everyone will assume that all others will have already responded, so no one will respond.

Of course, if markets are always in equilibrium, or when disturbed always adjust instantly to a new equilibrium, risk-adjusted returns across the markets cannot diverge from one another for any length of time, and no one can beat the market by picking a stock which might outperform the market. The conclusion is attached by a solid weld to the premise. But what is the value of this analysis and its incontrovertible conclusion which is assumed from the start?

What is at issue is just how quickly an efficient market adjusts. Does an "efficient market" share the characteristic of instantaneous adjustment with "perfect competition?" If it does, then "quickly" must mean "instantly" and there is nothing more to discuss; the whole idea can be relegated to the scrap heap of irrelevant intellectual curiosities.

But even if market participants are knowledgeable of relationships and perceptive of dynamic change, it simply does not follow that adjustment can be instantaneous. Those who perceive the changed condition earliest in time and act soonest to "sell high and buy low" can both gain advantage and precipitate market adjustment so that less-perceptive and slower-witted market participants will suffer the conclusion of the efficient markets hypothesis.

For the efficient markets hypothesis to be meaningful, it has to be more akin to "pure competition" which is not characterized by market perfection than it is to perfect competition which is practically unworkable. Are there entrepreneurial opportunities in perfect competition? None, because of the assumptions of perfection. Are there entrepreneurial opportunities in pure competition? Yes, but precisely because the assumptions of market perfection do not apply. Conditions change in both purely competitive and efficient markets (are we really talking about the same thing?), providing opportunities for entrepreneurship or arbitrage, but those opportunities will be fleeting because of quick (but not instantaneous) entry into the market. Only the perceptive and quick-witted can gain. The message is clear in old adages: "Make hay while the sun shines!" "Gather ye rosebuds while ye may." Because if you don't, others will and very quickly, but not instantaneously; there will be windows of opportunity in both purely competitive and efficient markets.

So, you should not be put off by the esoteric and irrelevant conclusions of the extreme variant of the efficient markets hypothesis. Yes, markets for financial instruments, commodities, and foreign exchange tend to be very efficient, but not to the point of perfection. You should go ahead, hone your knowledge of how they work, sharpen your perceptiveness of changing conditions, and practice your response strategies. By so doing you may increase the probability that you might get "in" soon enough to pick a stock that does better than average. It does not necessarily follow that you are equally likely to pick one that does worse than the average. The market may be efficient, but it is not perfect. Note that while the majority of those who "play the markets" about break even and there are some who lose bundles, there are also some who garner fortunes. Do the latter simply enjoy good luck in what amounts to an efficient lottery? The job of the student is to increase the probability that she or he can garner fortunes rather than lose bundles or just break even.