In 2007, Warren Buffett, one of the greatest investors in modern age, made a bet that the S&P 500 stock index would outperform hedge funds. He argues that over a period of time, active investment management by professionals would underperform the returns by amateurs who were passively investing. In September this year, Buffett confirmed the victory on his bet.
From his winning bet, many investors’ recall an old investment theory, Efficient Market Hypothesis (EMH). It is a theory developed in 1970s attempting to explain how the market reacts to relevant information.
The theory says stocks prices will always incorporate all of the available information and therefore stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. Passive investing is the suggestion for investors if EMH holds.
There are four major assumptions of EMH –
1. all information is freely available;
2. can buy & sell shares freely in market without significant costs;
3. can buy & sell without influence of a dominant buyer or seller;
4. not influence the market by investors actions.
Based on the assumptions, there are 3 basic types of EMH –
(a) Operational efficiency - the efficiency in which investors can buy & sell securities. There should be minimal transaction costs and the actions of individual buyers should not influence the market.
(b) Pricing efficiency - Prices of securities should reflects the available information. All prices reflect the fair value of the business projects.
(c) Allocation efficiency - If operational & pricing efficiency apply, available investors fund will be allocated to companies offering the best rates of return for a given level of risk.
In the past, many investors didn't believe EMH. Only in a perfect world which all EMH assumptions hold, stocks prices take into account all information so no investor can take advantage of other people’s ignorance. It indicates passive investing is the best strategy with a random walk on stock prices.
“Does EMH hold?” is always a debatable topic in investment world. We are not going to conclude EMH holds or not in real world. But after Buffett’s winning bet, we believe more discussions and studies on EMH by investment and academic experts will be seen.
Note: Common Forms on EMH
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