If a large majority of investors
believe in the hypothesis, they would all assume that new information about a
stock would quickly be reflected in its price. Specifically, they would affirm
that since news almost immediately moves the price up or down, and since news
can’t be predicted, neither can changes in stock prices. Thus investors who
subscribe to the Efficient Market Hypothesis would further believe that looking
for trends and analyzing companies’ fundamentals is a waste of time. Believing
this, they won’t pay much attention to new developments. But if relatively few
investors are looking for an edge, the market will not respond quickly to new
information. In this way an overwhelming belief in the hypothesis ensures its
falsity.
To continue with this cerebral
somersault, recall now a rule of logic: Sentences of the form “H implies I” are
equivalent to those of the form “not I implies not H.” For example, the sentence
“heavy rain implies that the ground will be wet” is logically equivalent to “dry
ground implies the absence of heavy rain.” Using this equivalence, we can
restate the claim that overwhelming belief in the Efficient Market Hypothesis
leads to (or implies) its falsity. Alternatively phrased, the claim is that if
the Efficient Market Hypothesis is true, then it’s not the case that most
investors believe it to be true. That is, if it’s true, most investors believe
it to be false (assuming almost all investors have an opinion and each either
believes it or disbelieves it).
Consider now the inelegantly named
Sluggish Market Hypothesis, the belief that the market is quite slow in
responding to new information. If the vast majority of investors believe the
Sluggish Market Hypothesis, then they all would believe that looking for trends
and analyzing companies is well worth their time and, by so exercising
themselves, they would bring about an efficient market. Thus, if most investors
believe the Sluggish Market Hypothesis is true, they will by their actions make
the Efficient Market Hypothesis true. We conclude that if the Efficient Market
Hypothesis is false, then it’s not the case that most investors believe the
Sluggish Market Hypothesis to be true. That is, if the Efficient Market
Hypothesis is false, then most investors believe it (the EMH) to be true. (You
may want to read over the last few sentences in a quiet corner.)
In summary, if the Efficient Market
Hypothesis is true, most investors won’t believe it, and if it’s false, most
investors will believe it. Alternatively stated, the Efficient Market Hypothesis
is true if and only if a majority believes it to be false. (Note that the same
holds for the Sluggish Market Hypothesis.) These are strange hypotheses
indeed!
Of course, I’ve made some big
assumptions that may not hold. One is that if an investor believes in one of the
two hypotheses, then he disbelieves in the other, and almost all believe in one
or the other. I’ve also assumed that it’s clear what “large majority” means, and
I’ve ignored the fact that it sometimes requires very few investors to move the
market. (The whole argument could be relativized to the set of knowledgeable
traders only.)
Another gap in the argument is that
any suspected deviations from the Efficient Market Hypothesis can always be
attributed to mistakes in asset pricing models, and thus the hypothesis can’t be
conclusively rejected for this reason either. Maybe some stocks or kinds of
stock are riskier than our pricing models allow for and that’s why their returns
are higher. Nevertheless, I think the point remains: The truth or falsity of the
Efficient Market Hypothesis is not immutable but depends critically on the
beliefs of investors. Furthermore, as the percentage of investors who believe in
the hypothesis itself varies, the truth of the hypothesis varies inversely with
it.
On the whole, most investors,
professionals on Wall Street, and amateurs everywhere, disbelieve in it, so for
this reason I think it holds, but only approximately and only most of the
time.
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