Since my stock posts tend to get the most traction, let’s try this one.  I wanted to post because I was recently made aware of the Efficient Market Hypothesis which essentially states (in its weak, semi-strong and strong forms) that you cannot beat the stock market.  The weak form states you can’t beat the market using prior performance, the semi-strong states you can’t beat the market using prior and current performance, and the strong form states you can’t beat the market using insider knowledge.  Essentially weak = Technical Analysis is useless, semi-strong = fundamental analysis is useless, strong = insider trading is useless.  Taken together, these hypotheses seem unappealing to a day trader or stock picker, as they suggest the only winning move is the boring play of buying whole-market ETFs.  And yet that also creates a weird contradiction because if everyone believed the Efficient Market Hypothesis, everyone (including banks, hedge funds, and investment groups) would just buy and hold whole-market ETFs and never trade stocks individually.  There would essentially be no stock market in that case!

But getting back to the hypothesis itself, why would it be true that you can’t beat the market?  Let’s start with the weak and semi-strong forms, which only make statements about publicly available information.  The hypotheses in this case are yet another statement about the wisdom of the crowd: all of us are smarter than any one of us.  If you try to use available information to guess the next moves of a stock, you will find that the next moves are already “priced in” because the market beat you to it, and so there is no way to buy low + sell high.  Before you want to buy the price will go up, and before you want to sell the price will go down because the market is always faster and more accurate that the individual.  On the face of it this seems like the joke about the two economist walking down the street: one says to the other “look, a 20$ bill on the sidewalk!” and the other says “ridiculous, there are no 20$ bills on the sidewalk, someone would have already picked them up!”  The fact is that there always has to be someone who was first to use some particular information, and does that let them beat the market?  On the other hand this hypothesis isn’t talking about individual events but averaging across all possible events.  Yes you may have bought early this time, but you can’t consistently buy early and so you’ll buy late and lose as often as you buy early and win.

As to the strong form of the hypothesis, it’s the least defensible because remember it basically states “you can’t make money via insider trading.”  The conceit is that in this case any insider information isn’t purely such, and the wisdom of the market can “price in” insider information thanks to the constant stream of rumors and leaks that even the tightest-run ship is subject to.  Still strong-form hypothesis proponents were quick to point out that this doesn’t necessarily mean insider trading shouldn’t be illegal, it can still be true that the actions someone will take in order to perform insider trading are harmful and so insider trading should be banned.  Hiding bad or good information, making very short term decision to boost the stock at the expense of long-term corporate health, these are all bad things, even if the people making them can’t actually make money off of them, the fact that they think they’ll make money is reason enough to ban insider trading as a practice.

So to finish this ramble, I don’t know if I believe the efficient market hypothesis.  The weak and semi-strong forms obviously seem the most defensible, but it’s important to remember that many well-regarded stock traders with long histories of success don’t believe it.  And what’s true in mathematical economics isn’t always true in reality