This is the final installment of Ed Rempel's "Is the Market Efficient?" series.  In case you missed the other articles, here you find Part 1 and Part 2

“If the world was perfect, it wouldn't be.” – Yogi Berra

My opinions about the Efficient Market Hypothesis (EMH) are not necessarily worth more than anyone else’s, but I have been reading and researching EMH for years. I’ve also heard many informed opinions about it.

I would have to say I believe in the “Weak EMH”. Why? There is a lot of evidence that markets are relatively efficiency and assimilate new information very quickly and usually effectively. EMH cannot be dismissed completely.

However, while most information is available to everyone, most investors make investment decisions based on very little information and often make their decisions primarily on emotional factors. The cognitive errors outlined in behavioural finance explain much of what really happens in the markets. Even professional investors are still human and also fall into these same traps.

Weak EMH claims that all technical analysis (charting) does not work except by luck. I believe that this is true for the most part. We’ve seen many people selling charting strategies, but have seen very few verifiable examples of anyone making a good return from them.

I think that someone sees a pattern that probably does not actually exist. Most patterns we see as humans don’t actually exist. Random stock movements will usually look like a pattern when you study them. Then a bunch investors start to see it and invest by it, which makes the pattern actually happen. Then more people find out about it and recognize the pattern and buy more quickly, which makes the pattern stops working. Once it stops working, then someone who saw it work for a bit starts to market it. (If it worked very well, nobody would market it. They would keep it to themselves.)

From what we’ve seen, the next level of “Semi-strong EMH” is doubtful. It would claim that fundamental analysis does not work, but we’ve seen too many examples of fundamental analysis working. All the exceptional fund managers mentioned in part 2 use fundamental analysis as part of their value style of investing. They study a company to figure out what it is really worth and only buy when they can get it 30-50% below that value.

Part of what we do as financial advisors is to constantly evaluate mutual and hedge fund managers to identify the very best and smartest for our clients. One of the most informative pieces of info is what a fund manager thinks of EMH. Fund managers that beat the index often have very insightful opinions on why they beat the index. Of course, many don’t or have opinions that probably come from something they read. Fund managers that don’t beat the indexes often dismiss EMH or claim the indexes are too risky for their investors.

For example, one of our fund managers is a value style investor that claims most stocks are mispriced most of the time. They work out what companies are really worth and claim most stocks sell noticeably above or below their real intrinsic value. They claim that the market tends to value currently popular companies well, but stocks that are out of favour often sell for much less than they are worth. This is a systematic market inefficiency that they claim to be able to take advantage of consistently (and their performance backs this up).

Another of our fund managers believes the market indexes are really a mutual fund run with specific principles. The index buys large liquid companies, has very little turnover, and dumps its losers and holds its winners – all of which generally work. Most mutual fund managers do the opposite of these. However, the indexes do very little research and so they often own bad or inferior companies. This fund manager systematically beats the indexes by doing what indexes do right and not what they do wrong.

Another fund manager believes there are many, many markets – not just one. Different markets are efficient to different degrees. The US has the most efficient stock market, with many other countries, especially emerging markets being much less efficient. Large cap stocks tend to be more closely followed and so are more efficient than small cap stocks. IPO’s are usually heavily marketed and there is usually less info than with established companies, so IPO’s are less efficient than the broad stock markets. This fund manager beats the indexes by buying undervalued companies and focusing on less efficient markets.

Top fund managers often have these types of profound insights into the EMH and the systematic inefficiency that allows them to beat the index. This is why I don’t believe the “Semi-strong EMH” or “Strong EMH”. Fundamental analysis of stocks quite often produces better returns – much less than half the time but enough to prove it can be systematically done.

Much of the time, top performers were just lucky or their style just happened to be in favour, as EMH claims. However, a few skilled investors can identify and take advantage of systematic inefficiencies in the markets and are disciplined enough to take advantage of them.

Now that you have a general understanding and possibly an opinion on EMH, how does this affect your philosophy about how to invest effectively?

Thanks to Ed Rempel for another thought provoking series of articles.  If you have questions, feel free to leave them in the comments. 

If you would like to read more articles like this, you can sign up for my free weekly money tips newsletter below (we will never spam you).


  1. FourPillars on November 22, 2007 at 1:17 pm

    One point about irrational investors – over the last few decades the percentage of trades on the stock markets has gone from 10% institutions/ 90% (irrational) investors to the opposite today – 90% institutions and only 10% investors.

    My point is that the irrationality of investors (which I don’t disagree with) may not be a big factor in today’s markets although you could argue that professional money managers aren’t necessarily more rational.

    I couldn’t agree more with your technical analysis opinion (sorry FT!) and your point about different types of markets and large cap/small cap is also very good.

    I still have to disagree with you that some fund managers can beat the index on a regular basis – I need solid proof. I know you’ve given some great examples of this but the list didn’t include any Canadian managers which would be of more relevance to Canadians.

    Thanks for a great series, I really enjoyed reading it!


  2. Plan Your Escape on November 22, 2007 at 3:01 pm

    I tend to believe that markets are efficient in the long term and irrational in the short term … largely based on what I’ve read and what I’ve observed in my investing career.

    I totally agree with your theory that if someone had “a system” then they would not market it. If you can make more money selling your system than using it, it isn’t that great of a system.

  3. Gates VP on November 23, 2007 at 1:57 am

    Inhereent to the nature of a system that “beats the market” is that you can’t give it to too many other people. That’s the very nature of market inefficiencies, if everyone knows about them, they’re not inefficient any more.

    “Dogs of the Dow” is the simple example of this. Without putting on my contrarian hat here, the market is fundamentally a zero-sum game with “the house” chipping in 8-10% / year. You can’t outperform if you’re not using strategies that beat everyone else. The moment that “everyone” knows what you’re doing, it’s simply no good any more.

    And oddly, that’s the problem with trying to prove Strong and Semi-strong forms of EMH. Working strategies don’t work forever and efficient markets will change the cycles and cause some other strategy to be viable. So it’s really easy for academics to “disprove” inefficiencies, you just apply the “practice” to a period where it wasn’t applicable. But underneath all of this there are tons of people making tons of stupid decisions and blowing their house-given 10% (and then some).

    I’m not saying that it’s an easy game, but it’s a very big game none the less, and there’s definitely a lot of leeway for making money.

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