The stock market can somehow see the future. At 11:38 a.m. on January 28, 1986, the space shuttle Challenger launched, and about two minutes later… It took more than five months to conclude that the explosion was caused by the shuttle’s O-rings on the right solid fuel booster rocket, which was attributed to a company, Morton Thiokol, one of four NASA contractors.
About 20 minutes after the explosion, all four contractors’ stocks went down, and Morton Thiokol was hit the hardest. Investors dumped their stocks so much that a trading halt was called. That day, nobody knew who was to blame, but somehow the markets knew. It’s an interesting case of the wisdom of the crowds and how markets reflect information that might not be entirely obvious to us in the moment.
The Efficient Market Hypothesis (EMH) is a theory in financial economics that posits that financial markets are “informationally efficient,” meaning that asset prices fully reflect all available information at any given time. Developed by economist Eugene Fama in the 1960s, EMH suggests that it is impossible to consistently achieve higher-than-average returns through stock-picking or market-timing strategies because any new information that could impact an asset’s price is quickly incorporated into its value. Breaking news about your company’s stock? The market already knew this before you, and it’s already priced into the stock. A war broke out, impacting macroeconomic trends? Bankers saw this risk three weeks ago, and it’s all priced in. Jerome Powell and Janet Yellen start an OnlyFans to offset U.S. national debt? Priced in. And subscribed—God bless America.
EMH is generally divided into three forms based on the level of market efficiency:
- Weak Form: In this form, EMH asserts that current stock prices reflect all historical price and volume information. Therefore, technical analysis (which relies on past price trends) is ineffective at predicting future price movements because all relevant past information is already factored into the current price.
- Semi-Strong Form: This form suggests that stock prices reflect all publicly available information, including financial statements, news reports, and economic indicators. As a result, neither technical analysis nor fundamental analysis can give an investor an edge. New information is quickly and accurately reflected in stock prices.
- Strong Form: In the strong form, EMH states that stock prices reflect all information, both public and private (insider information). If this were true, not even insiders could achieve superior returns, as all relevant information is already incorporated into market prices. This one seems pretty obviously false, although we might want to ask Nancy Pelosi.
Implications
The EMH has significant implications for investors and the broader financial system. If markets are truly efficient, then attempting to “beat the market” becomes a futile endeavor. Prices fully reflect all available information, so there’s no use trying to pick winners or losers or time the market. The most prudent investment strategy is to invest in index funds to get market-average returns over time. Also, diversify—no single stock or asset is likely to outperform the market on a consistent basis—so holding a broad portfolio of different asset classes is wise. This is what I do because information about the markets scares me.
There are also implications for the corporate world. For example, if a firm’s stock price accurately reflects all available information, managers should focus on maximizing the long-term value of the firm, as stock price manipulation or short-term strategies will have little lasting impact. EMH also makes active fund managers obsolete. If markets are efficient, it becomes difficult for fund managers to consistently outperform the market. This explains why many actively managed funds often fail to consistently beat their benchmarks over long periods, especially after accounting for management fees and transaction costs. The winners are due to pure luck, an unfair advantage, or being Bill Hwang.
Financial market regulators, such as the SEC, often operate under the assumption that efficient markets protect investors by ensuring that prices reflect all available information, so market transparency and the free flow of information are prioritized. Policies aimed at preventing insider trading are grounded in the EMH, as insider information would give certain investors an unfair advantage, thus undermining market efficiency. Government intervention in financial markets should be minimal because markets are already efficient. Policies aimed at enhancing market transparency or ensuring information dissemination are prioritized, while excessive regulation, which could distort market prices or hinder the free flow of information, is often discouraged. What’s up, Ayn Rand?
Criticisms
Despite its widespread acceptance, EMH has been criticized on several grounds. Critics argue that there are instances where markets do not seem to behave efficiently, such as during financial bubbles and crashes, when prices deviate significantly from intrinsic values. Scholars term this the “madness of the mobs.” In fact, the Nyberg report in 2011 on the causes of the Irish banking crisis identified a widespread belief in the efficiency of financial markets as a contributing factor. Some behavioral economists argue that this suggests markets are not driven by the rational use of information; rather, they are driven by fear and greed. Which would be an obvious insight if you take a glance at WallStreetBets.
Moreover, some empirical studies have shown that certain strategies, such as value investing, can sometimes outperform the market, suggesting that markets may not always be fully efficient. The success of value investing, as popularized by investors like Benjamin Graham and Warren Buffett, challenges the strong form of EMH. If markets were perfectly efficient, it should be impossible to consistently outperform the market using publicly available information. Yet, some value investors have managed to do so over long periods. Other anomalies, such as the small-firm effect (where small-cap stocks tend to outperform large-caps over time) or the January effect (where stocks tend to rise in January), also suggest that markets may not always be fully efficient. This is not a suggestion to be very active with your investments; rather, it is a warning against being overly passive. You need to be versatile, like the guys on that famous trading app… Grindr.
Andrew Lo, an MIT professor of finance, argues that markets are adaptive rather than always efficient or always irrational. His Adaptive Market Hypothesis applies principles from evolutionary biology to financial markets. It views the market as an ecosystem where various species (different types of investors) compete for scarce resources (profits). This competition drives adaptation and innovation in investment strategies. Investors adapt their strategies based on past experiences and changing market conditions. This adaptation can lead to periods of relative efficiency when strategies are well-matched to the environment and periods of inefficiency when there’s a mismatch or during times of significant change.
The AMH acknowledges that investors are not fully rational, as assumed in the EMH, but neither are they always irrational. Instead, they exhibit “bounded rationality,” making decisions that are “good enough” given their cognitive limitations and the complexities of the market environment. Different investor types (e.g., retail investors, institutional investors, high-frequency traders) form a market ecology. The interactions between these groups, their relative proportions, and their evolving strategies all contribute to market behavior. The AMH explains market phenomena like bubbles, crashes, and trends as part of natural market cycles. These cycles emerge from the continuous process of competition, adaptation, and evolution of market participants and their strategies. A really novel and interesting contribution to the scholarly literature. Now, how do I make money out of it?
Conclusion
The Efficient Market Hypothesis remains a cornerstone of financial theory, profoundly influencing passive investment strategies and the development of index funds. However, ongoing debates about market efficiency have led to more nuanced perspectives. The implications of these theories span multiple areas of finance, from investment strategies and corporate decision-making to market regulation and risk management.
Understanding both EMH and its critiques provides a more comprehensive framework for financial professionals, encouraging a balanced approach that recognizes the general rationality of markets while remaining alert to potential inefficiencies. In practice, this might mean maintaining a core passive investment strategy while allowing for some active management to exploit market inefficiencies. For me, this means buying Costco gold bars until Roaring Kitty tweets something.
Ultimately, these theories serve as critical tools for understanding how information is reflected in asset prices and how markets behave over time, reminding us that while markets are generally efficient, they are also complex, adaptive systems influenced by human behavior and changing conditions. Crowds can be wise, and mobs can be mad.
Body of Knowledge 
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