What Is the Efficient Market Hypothesis?

Brad DeLong cites Underbelly citing The Economist quoting Richard Thaler:

The [Efficient Capital Markets] hypothesis has two parts, he says: the “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.

I think this is exactly right. Ever since graduate school I have said that I believe in efficient markets, by which I mean the “no-free-lunch part.” The idea that some people might think that “no free lunch” implied that “prices are right” didn’t even occur to me at the time. My thinking was basically like this: yes there are bubbles, but it’s hard to tell if you are in one, and even if you can tell, you can’t tell how long it will last so you can lose a lot of money betting against it, and even if you have a very long time horizon, who’s to say you won’t be in another bubble when you finally want to sell? Put another way, you may be “right” about an asset price, but if the market is composed of lots and lots of people who are “wrong,” and those people are never going away, what does that get you?

More fundamentally, for an interesting asset like a share of stock (or a house), what does it even mean for a price to be “right?” Sure, ten years later you can see what the dividends have been for ten years and what the stock price is on that date, but that price is no more “right” than any other price; it’s still a collective, irrationality-tainted guess about the future. Future states of the world are not only unknowable right now, they dont’ exist right now, so questions of right and wrong don’t even apply to them. There are just better and worse estimates, and there will never be any way to determine which estimate was better. (Just because things work out a certain way doesn’t imply that that was the most likely outcome.)

I think I’ve beaten this question into the ground recently, so I’ll stop there.

By James Kwak

31 responses to “What Is the Efficient Market Hypothesis?

  1. DesolationRow

    I would agree with this for 99.9% of the population. However, if you’re a certain investment bank whose name starts with “Gold”, there is such a thing as a “free lunch”. For this certain bank had the foresight and smarts to install its alumni into the highest regulatory positions in the land…and thus now has immense sway in Washington. After reading the expose in the current Rolling Stone on Goldman Sachs, I’ve realized the only thing greater than the greed in that bank is their collective hubris.

  2. It is very doubtful that those who came up with the EMH contemplated a financial system that was entirely back stopped by the federal government. Certainly no free lunches in the big scheme of things.

  3. It remains possible that the efficient markets hypothesis would work in a “genuine free market” absent various government policies. The housing bubble developed against the backdrop of “too big to fail” and other government policies that encouraged the bubble.

    A better statement would be that either the efficient markets hypothesis has taken a beating in current events or the unstated assumption that the market in question is a “genuine free market”.

    The paradox is that policies designed to benefit certain companies or groups of companies are frequently labeled as “free market”, “private sector”, “market based”, “market friendly”, or similar phrases. This hides the reality that the policies are government intervention on behalf of certain companies or groups of companies.



  4. You lost me at the “no free lunch” part.

    Because there are bunches of people eating magnificent lunches for free these days.

    They work for the few, the proud, the profitable TBTF institutions that risked big during the boom, hedged not enough with AIG and somehow found a way to make other people’s money pay for their bonuses….

  5. A win for Keynes and his theory of not so efficient prices

  6. I’ve always believed that there really are no good or bad decisions in finance and business, only decisions that are made good or bad by subsequent events. All the ‘winners’, of course, believe they were smart, but how many could still say that if events had taken a different course? Well… none.


    Which is why “skin in the game” is absolutely required.

    The speculators with 0 down, and the Pig men on Wall Street with OPM, Govt backing, 33% leverage…none had anything to lose.

    There is one and only one solution to bubbles – You want to play? Put your neck on the line.

  8. Chris Jones

    I think the quote is exactly right. Buffett offers two great explanations for why indexing is a good strategy, despite the fact that the EMH is ‘badly dented’.

    One is his essay ‘How To Minimize Investment Returns’ (you can google it).

    The other is this simple argument: All investors must in aggregate achieve the average/total market return. Since the group ‘all investors’ is composed of entirely of active and passive investors, and since passive investors achieve the average return, active investors must also achieve the average return. However, since active investors incur higher costs than passive investors, in aggregate over the long term they will underperform passive investors by approximately the amount of their excess expenses.

    This small advantage for passive investors is a little like the house advantage in Las Vegas. In any one year, a gambler might beat the house, but the chances of beating the house overall if you go every year for 30 years are exceptionally low.

  9. Wow, you took the words right out of my mouth Dave. Great minds think alike?? If you look at John Maynard Keynes’
    “The General Theory” Chapter 12, more specifically pages 154-164, he elucidates his thoughts pretty well there. And probably other places in Keynes’ writings.

    I go back in forth in my own mind on EMH. But basically to say prices are all correct is hogwash, and all of us intuitively know this. Saying prices are correct or incorrect is an argument that will take you around in an endless loop of thought and an endless loop of debate. It’s basically the same as the question “Which came first, the chicken or the egg?” If you think you know then place your bets accordingly.

    The guys who do know the “correct” or “real” price (guys like Warren Buffet, George Soros, etc.) probably aren’t going to get a bullhorn and share that information until AFTER they bought whatever they thought was undervalued. And if YOU knew the “correct” price of something the market priced wrong, would you broadcast that knowledge to the world?? Again, not until AFTER you had bought it.

  10. The “no free lunch” part is quite misleading. It is in the eye of the beholder.

    Let’s say in a particular transaction, I managed to gain 100 $ “out of” you and you “lost” 100 $ because of me.

    Both of us combined, there is “no free lunch”. However, I managed to have a “free lunch” in this context.


    Also Sprach Aristoteles. :)

  12. The famous Efficient Market joke:

    You’re strolling through a park with an efficient market theoretician. You spot a $100 bill in the grass. The theoretician: “Don’t even think of stooping to pick it up! It doesn’t exist. If it existed somebody would have picked it up before you.”

  13. Classic. Thanks Swan

  14. hugh manist

    Markets are effective, not efficient, probably the most effective form of rationing (distributing supply and demand) ever devised and do the best possible job putting the future into the service of the present. No amount of command and control, or computer model, will ever come close to being as effective for most of the people for most of the time.

  15. Conclusions drawn from two bubbles:
    1) Experienced people know when they are in a bubble: they know it can burst, and they know they have little time to get rich.
    2) They don’t know when it’ll blow up.
    3) They can’t probably beat the market but they may beat a large part of it: 1) the people who don’t understand they are in a bubble; b) those who haven’t understood it has blown.

  16. I am familiar with the “price is right” version of the hypothesis, which I used to bet against. The “no free lunch” version, I don’t know. Does it mean, “only fleeting opportunities for arbitrage”?

  17. There are two aspects to the stock market: relative valuation and absolute valuation.

    Relative valuation (price of one stock/bond/currency/option/etc versus another) is extremely efficient, but that doesn’t mean you can’t beat the market or that the winners are chosen randomly. You CAN beat the market, just like you CAN win the Olympics. All you need in the case of the Olympics is a combination of very hard work and natural athletic ability. All you need in the case of the stock or other financial markets is hard work and a natural trader personality. By hard work, I mean equal to that of the other winning traders–a few hours a week just won’t cut it.

    Absolute valuation (the overall level of the stock market) is very inefficient. The reason is that there simply aren’t enough players with a long-term investment horizon. Most institutions have an investment horizon of at most 2 years. In particular, institutions will fire any manager who goes all cash for more than 2 years while the market is overpriced. And yet the rational thing was to go all cash in 1998 and then stay all cash until Oct 10, 2008. That’s 10 years of going against the herd. Only individual investors are allowed to go against the herd for long periods, and it takes a special personality to do this, which is why the market is so ineffecient in terms of absolute valuation. There is no magic here, just use Shiller’s PE10 or Tobins Q ration (computed using Fed Z.1 data) as a guideline for when the market is expensive versus cheap versus somewhere in-between, and then come up with a strategy for dealing with transitions from one state to another.

    Right now, the market is clearly between cheap and expensive. So you should have some money in stocks and some money out of stocks, in preparation fo the market going either up or down. If it goes up a lot and becomes expensive again, then sell what you have. If it goes down a lot and becomes cheap again (like it was Mar 9, 2009), then buy some more stocks.

  18. The point I take from the Efficient Market Hypothesis is that the “right price” is determined when all information is processed by the market. In our case here, maybe the price was right considering the incorrect information the market had, the intervention of outside parties, and the distorted information due to other incentives(taxes, politics etc). Either way it is nice to have to think about all the crap I gobbled up in college without question.

  19. I was told hedge funds made money by spotting mis-pricings.

    Is arbitrage the word for that?

  20. winstongator

    I started my career in tech (analog IC’s) in 98. Saw lots of people gambling with dot-coms and telecom stocks. Thought they were a little pricey, invested in a diamond instead.

    Have family in So FL. Moved to NC in 2003 and stayed because of the frenetic housing market there. Even buyers in lots of FL from 2003 are now underwater. If you stretched to make the payment in 2003, you’re pretty much screwed now. While it is hard to get rich off betting against a bubble, it is much easier and I would say possible to avoid huge losses.

    To ‘cash-in’ on housing all one would have had to do was buy in 03, sell in 06, and then rent or temporarily trade-down. If you really thought that your home was twice as valuable, then you held on, perhaps hoping for more. Otherwise it would have been easy to cash out. I remember reading somewhere that Clinton changed the tax treatment for cap gains from home sales, but don’t remember the details.

  21. Very Nice, John

    The idea that Crony Capitalism works, whether marketed under the guise of some beneficial sounding social engineering program or some straight out payoff to a contributor should be the idea under scrutiny. Wall Street has not been a free market for some time.

  22. markets.aurelius

    Markets are efficient, but that is not to be confused with right all the time. They are extraordinary organisms — or, more correctly, self-organizing systems. They process all available information continually. As new information arrives these markets modify, morph and transform a pre-existing view of reality into a new one more consistent with the new set of facts and knowledge upon which they’ll allocate risk and capital.

    The best piece ever written on this was Fischer Black’s Noise (1986). Here’s a very good treatment of it:


    And here’s the article itself:


    Not a lot to be said beyond that. Other than, in your earlier post, James, you hit on the real problem: Regulators that did not regulate. As I plow thru the wreckage of these markets I literally am stunned at the complete failure of the SEC in the Clinton-Bush years.

    There was a collective recusal from reality in those years as everyone came to believe the Rubin-Greenspan mythos about efficient markets, and the near-mystical ability of financial markets to self-regulate. It is looking more and more like belief that became dogma, to all of our everlasting regret. Once a set of beliefs becomes dogma we’re all lost.

    And now we have federally subsidized former investment banks operating as if they still were legit investment banks, taking the money an efficient market would require of them to borrow at a cost truly reflective of the risk in their balance sheets, and dispersing it as comp for a job well done (GS, JPM, et al).

    These folks know — as we all know — they cannot survive as stand-alone entities. And yet, as wards of the state, they can expand their VAR to multiples of what it was in their best years, and compensate each other as if they really have managed their way into their best year ever. If they had to pay even a fraction of the cost of longer term funding at the price the market set (instead of at the rate the fat and drunken Dionysus known as the Fed dispenses in its overwhelming exuberance), they’d likely not be able to pay anything to anyone other than interest on their risky debt.

    The balance sheet should contract and expand as a function of the VAR and its modeled effect on the equity of the owners. But now, given these former investment banks will not, under any circumstance, be allowed to fail, they can expand their VAR to gargantuan proportions, far in excess of anything the equity of the firm could sustain on its own, and, if they’re right, be paid like Midas himself. If they’re on the wrong side, who cares? They show up for work they next day, and get to swing for the fences again. It’s nirvana — a money machine that cannot do anything but pay extravagant sums to the people taking risk on the Fed’s balance sheet. They very people that destroyed the global capital and trading markets, along with the mortgage and housing markets worldwide.

    Has it struck anyone that these high priests of efficient markets continue to use the same incantations that rendered everyone in the markets — on the private and public sides — somnambulant to argue that they should be sustained as wards of the federal government, so they can reap ungodly bonuses this year, and maybe next?

  23. No free lunch: When you trade with a nation and create a trade deficit, you enter a state of economic balancing, where one country will become poorer to make the other richer, until both reach a level where the trade deficit is reduced to zero. In the case of the US and China, it means the US’ trade deficit will continue to exist until its standard of living falls enough and China’s rises enough so, at which point unbalanced trading between the two will stop. If the US’ standard of living falls further than that, the trade deficit could occur the other way around.

    People often dismiss this idea, saying that there is no way that the US standard of living would fall as low as China’s. But you must take into account the population difference, and income difference, the varying levels of contribution to the trade itself of each citizens, to establish what the standard of living is in China. The more an individual in China contributes to his country’s trade surplus with the US, the more place he takes in this “standard of living” level. In the US, the more an individual contributes to his country’s trade deficit with China, the more place he takes in this “standard of living” level.

    After taking this into account, then maybe you can see that it isn’t far fetched that the US’ standard of living will fall until a balance is reached.

    There is no free lunch.

  24. “The Monks of Cool, whose tiny and exclusive monastery
    is hidden in a really cool and laid-back valley in the lower Ramtops, have a passing-out test for a novice. He is taken into a room full of all types of clothing and asked: Yo¹, my son, which of these is the most stylish thing to wear? And the correct answer is: Hey, whatever I select.

    ¹ Cool, but not necessarily up to date.”

    Terry Pratchett, “Lords and Ladies”, 1992

    I’m not an economist and I probably don’t understand a lot about the EMH but I’ve always thought that the above quote is very similar to the price-is-right part. To put it in another way, I think it’s wrong to say that the price is “right” since we don’t really have anything to measure it against. If we did we’d already know the right price and we wouldn’t need the market.

    The way I see it, the right way to put it is that we don’t have any mechanism to set the price because it’s dependent on transient conditions of supply and demand and a large number of bits of information that we can’t objectively evaluate (or even be aware of). Therefore we can’t really tell what the right price is. So the right price is whatever the market, much like the novice monk, selects since it presumably incorporates all the relevant information. That’s not really wrong but if you put it that way it’s clearly tautological. And as such it’s not really useful (what good is it to know that A=A?). The question about bubbles brings the tautology, and eventually the usefulness of EMH to focus: if the market price is always right by definition there’s no such thing as a bubble (some people argue that this is true, read for example Krugman’s blog post “Ketchup and the housing bubble”).

    Since it is obvious to most people that there are in fact bubbles, EMH proponents usually explain away the phenomenon by attributing the price anomalies to external factors (i.e. the government). This is dodgy: it is not clear why government intervention differs from other information already successfuly incorporated into the market determined price (and which is by definition “right”). It sounds a lot like an ad hoc explanation for something that would disprove the hypothesis. If the price seems ok the market has clearly worked it’s magic, if it doesn’t then someone else is to blame. Which brings us to another point: since it’s shaped like a tautology and supported by ad hoc explanations it seems EMH is not falsifiable and therefore highly questionable.

    Sorry for the wall of text, it’s just the thoughts of a layman.


    Kyriakos (from far away, I’m European – great blog btw, congrats)

  25. Does this even matter, are we saying economic signals can change our level of happiness and misery. Is human emotions a measure of quantity.

    This is important, we need to figure out a correlation first.

    Please visit http://karmaeconomics.blogspot.com/

    i have tried to find answers to basic questions that i find it no where, but are the essence of what we are. Thanks.

  26. This is a very strong argument.

    It’s made even stronger by empirical studies of the variance in the return of active investors. Because that shows that although some active investors always do get above the average, it is usually not the same investors over time. And that in fact if an active investor does get above average return over a period, it is more likely that he or she will get below the average return in the next period.

  27. BlueMoonChimneys


    I started to say that this is false, but on second thought I will say not that it is false, but that it is disastrous. We have put the future so much at the “sertvice” of the present that we are in the process of impoverishing the future in order to have our affluent plethora of stuff in the present… at least some of us.

    It never ceases to amaze me how divorced from reality these arguments become.

  28. Can the US stockmarket continue to rise without a) inflation b) continuing to be dominent economically and c) with “free” natural resources now becoming harder to obtain or utilize? That is to say, why shouldn’t the market be relatively flat and stocks pay a fair dividend?

  29. Eric Dewey, Portland, Oregon

    Don’t stop, James – you’re onto something that may be quite important. Let me take a couple of liberties:

    “More fundamentally…what does it even mean for a price to be “right?” [any one]price is no more “right” than any other price; it’s still a collective, irrationality-tainted [point-in-time] guess about the [likelihood of a posible] future [value that may occur in the minds of the “market”]. Future states of the world are not only unknowable right now, they don’t exist right now, so questions of right and wrong don’t even apply to them.”

    This reminds me of the Schrodinger’s Cat thought experiment that caused Einstein such problems. In order to know if the cat in the box is alive or dead, we have to open the box measure the state of the indeterminate quantum particles inside – but opening the box determines the state of the particles.

    Similarly, in order to know whether the present value we ascribe to something is accurate, we will need to move into the future (at least by one step: deciding or choosing not to decide) – but in doing so, the future is affected by our decision (or lack of decision), and is thus determined.

    Is it possible that the size of the global economy has grown to such a point that the insights of quantum theory apply? That there are so many individual events, transactions, decisions, or inflection points interacting to create our economic “reality” that present values of an individual “thing” are as mathematically indeterminate as physical quanta?

  30. This efficient market joke has persisted for too long. It’s easy to beat the straw man, which is the strong form of EMH. Behavioral Finance theories have already cast doubt on the strong form… how many people really believe the efficient market is ALWAYS efficient?

    The semi-strong form of EMH does not hold that markets are ALWAYS efficient, but that markets are VERY efficient, such that you will have great difficulty in beating the median.

    So the efficient market theoretician will tell you that you better pick up the $100 bill really quick, because it’s not going to be there for long.

  31. Another variation of the joke has the $100 bill lying on the sidewalk of mid-town Manhattan, presuming with lots of foot traffic.

    The efficient market theoretician will definitely pick it up, because it will not remain there for long. He also realizes that such an opportunity rarely exists, and it’s unlikely that he will ever encounter such an opportunity again.

    Might as well use the joke to show the market’s high level of efficiency instead. This is most evident in the pricing of SP500 stocks, or even the mid caps. The price may not be “right”, but it represents the collective guesses of the masses, which integrates fundamental analysis, as well as “emotional analysis.” So try to outguess it at your own peril, unless you’re Warren Buffett.