The efficient market hypothesis (EMH) is the hypothesis that stock prices reflect all currently available information and are always “fairly valued.” Under this assumption, it is considered impossible to “outperform” the market through skillful stock selection or market timing. In essence, this theory postulates that if a stock trades for $5, that $5 valuation represents the stock’s intrinsic value, in addition to what current information allows investors to discern about the company’s future cash flows. Those who believe in EMH think that “alpha”—an investor’s ability to beat the market—is impossible.
EMH relies on neoclassical economic assumptions of rationality. These assumptions, while useful for constructing economic models, do not always reflect real human behavior and choices. The key assumption of this worldview is that people have “well-defined preferences and make well-informed, self-interested decisions based on those preferences.” The observation of behavior that contradicted this worldview led to the development of a new branch of economics known as behavioral economics. Behavioral economics focuses on the “irrational” aspects of human behavior that contradict the neoclassical model, such as loss aversion and hyperbolic discounting. These tendencies have also been explained through the lens of evolutionary psychology and “ecological rationality.”
Prospect theory from behavioral economics suggests that humans experience losses more intensely than equivalent gains. This tendency leads individuals to approach risk and reward with caution, exhibiting risk aversion. Daniel Kahneman and Amos Tversky formulated this theory based on experimental observations. If financial markets consist of participants who feel losses more acutely than gains, it is likely that these markets will not behave in accordance with the EMH. This is just one of many cognitive biases that can influence investor behavior.
EMH’s assumption that asset prices reflect all available information is not realistic. The Austrian economist Friedrich Hayek proposed an alternative theory, suggesting that prices convey information during the competitive process, rather than reflecting all available information. The ability for individuals to leverage knowledge, even colloquial knowledge, refutes EMH’s assumption about information. For example, Andrew Henderson, the founder of “Nomad Capitalist,” invested in the Bank of Georgia’s (now Lion Finance Group) stock simply because, in his line of work, he knew that “as a customer of that bank… I’m going to follow the Peter Lynch model.” Lynch is a prominent investor who is famous for saying, “Buy what you know.” In recent years, this stock has outperformed the market dramatically and is up nearly 800% since the bottom of the COVID-19 market correction in April 2020. By comparison, the S&P 500 is up roughly 170% in the same time frame. This example appears to illustrate that informational edges do exist.
Furthermore, the availability of information does not guarantee that it is interpreted correctly or in the same way. One of the fundamental problems with signal analysis is that the same stimuli can lead to opposite conclusions. For example, seeing a heavy police presence in a neighborhood can lead to two opposite conclusions about whether or not the neighborhood is safe. This duality is true of most signals. Layoffs can be seen as a sign of economic weakness, but they can also be viewed as a means to increase future profitability. In such scenarios, the ability to accurately interpret signals, whether due to experience, education, or natural disposition, can give traders a competitive edge.
There are also structural aspects of financial markets that lead to outcomes divergent from those suggested by the EMH. Ever since John Bogle invented the index fund, passive investing has become the dominant approach in financial markets. Passive investing has risen from 1 percent of investing to over 50% in 2024. The immense volume of capital invested in passive index funds has propped up certain equities to levels that would likely not have occurred otherwise. As explained by the brokerage firm Charles Schwab, “Getting listed on the S&P 500 can help shares of a company, at least momentarily, often by simple mathematics.”
According to Dimitri Vayanos, Professor of Finance at the London School of Economics, one of the issues with passive investing is that “if an active manager thinks that the market overvalues a company, then they may choose not to hold it at all—but a passive fund would hold it with a high weight.” By traditional benchmarks, the price-to-earnings (P/E) ratios of S&P 500 companies are currently incredibly high. Home Depot, for example, trades at an aggressive P/E ratio of nearly 25. Without immense volumes of passive capital, it is unlikely that a big box store like Home Depot would be priced as if it were an aggressive growth company.
EMH also presupposes that the only way to make money investing is through expected utility, but this overlooks the multifaceted nature of investing and the various ways in which traders generate profits. In a video by Bloomberg Originals, financial markets are compared to both blackjack and poker. The way that gamblers can gain an edge in blackjack is through card counting—a tactic in which players memorize cards and use probability to gauge expected value. This type of strategy is similar to fundamental analysis. However, according to the video, investing can also be like poker—where investors “build strategies not just around market fundamentals, but around the behavior of other participants.” Such a strategy would not be possible if equities were always fairly valued; there would be no player behavior to predicate such a strategy around.
Some facets of investing have also been likened to a Keynesian beauty contest. If a traditional beauty contest is composed of judges who vote for the contest they deem to be the most attractive, a Keynesian beauty contest seeks to be one in which judges are rewarded for trying to predict the face that the other judges find the most attractive. This concept, when applied to investing, means that “it suggests that investors profit more by anticipating popular stocks, rather than those with intrinsic value, leading to irrational price fluctuations,” as reported by The Decision Lab.
Valuation, from an EMH perspective, is almost platonic in nature. The theory does not allow for the consideration of the subjective elements of valuation. The truth is that valuations are often relative to one another; in order to understand if an equity is overpriced, investors often compare a company’s metrics to those of its industry peers. What is considered overpriced or underpriced can differ significantly by industry. If a tech company has a P/E ratio of 18, it may appear to be “undervalued,” but the same would likely not be true for an oil tanker company with the same ratio. By this logic, investing is not a matter of understanding fundamentals, but instead of understanding how fundamentals relate to human conceptions of valuation and price.
The definitive argument against the EMH is the existence of funds that consistently outperform the market. This outperformance is not simply due to statistical chance, as these same funds manage to exceed market returns year after year. One notable example of this is Renaissance Technologies, a fund that has attained an annualized return of 66% between 1998 and 2021. If EMH were true, this would be impossible to achieve.
The efficient market hypothesis may be useful to use as a starting point for some investors, but there are numerous reasons to doubt the theory as an explanatory model. If economists and social scientists want to understand financial markets properly, a multidisciplinary approach that goes beyond the hypothesis is necessary.
