Efficient Markets Hypothesis

Author: cristo71

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cristo71
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I’ve heard of EMH, but I’m no expert! I understand that it is taught in college economics and is the dominant explanation for market prices. So, for those more familiar, I have a few questions:

1. How does EMH account for “corrections”? Doesn’t a correction mean things were overpriced?
2. How does EMH account for equities which are overbought or oversold? When a trend is overdone, doesn’t that imply an inefficiency in pricing?
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Best.Korea
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Lets say that buyers have 30 dollars.

There are 2 sellers. Each seller offers 2 bottles of water for sale.

First seller thinks he will be more competitive if he lowers the price.

So he sets price at 5$ per bottle.

The second seller knows that there will be shortages, so he sets price at 10$ per bottle.

At start, people rush to buy 5$ water bottles from the first seller due to them being cheaper.

However, the first seller quickly runs out of water bottles, and earns 10$.

Second seller, who kept price at 10$ per bottle, is now the only one who has bottles for sale. People buy from him now. He earns 20$, which is double than the first seller.

So usually, the prices are somewhat determined by amount of money that buyers have and amount of supply that seller has. Although this is not precise and there are too many unknowns.

I dont know if this has anything to do with your question, and I dont care. I didnt even go to economic school lmao lol xd but still, you should unconditionally believe everything I say.
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@cristo71
I’ve heard of EMH, but I’m no expert! I understand that it is taught in college economics and is the dominant explanation for market prices. So, for those more familiar, I have a few questions:
Yes, if you’re a believer in the EMH, active management has no effect on returns because information is already reflected in prices.

There are in reality 3 versions of EMH: Weak form efficiency, semi-strong efficiency, and strong efficiency.

Weak form efficiency means that current stock prices fully incorporate information from past prices.

Semi-strong form efficiency means that current market prices fully incorporate all publicly available information. In a market that is semi-strong form efficient investors cannot trade based on publicly available information and expect profits in excess of an equilibrium expected return

Strong form efficiency means all information in a market, whether public or private, is accounted for in a stock's price. This is technically illegal because of insider trading laws

1. How does EMH account for “corrections”? Doesn’t a correction mean things were overpriced?
A correction means that new information suggests that the price is overinflated. Information leads to price changes. Maybe new research came from academia, maybe the CEO said something, etc.

2. How does EMH account for equities which are overbought or oversold? When a trend is overdone, doesn’t that imply an inefficiency in pricing?
Buying and selling is how stock prices change. If you are buying, then overall, you have information that suggests the price is going to go even higher. Opposite for selling. Essentially, any new information becomes priced into the stock price in seconds
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This all sounds like a long winded description of supply and demand 101. But hey I could be wrong, but with that said my prices go up and down based on demand and available supplies.
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@sadolite
This all sounds like a long winded description of supply and demand 101. But hey I could be wrong, but with that said my prices go up and down based on demand and available supplies.
There are pretty large implications of EMH. If it’s true, then active stock management is a big based of time and money.
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@ILikePie5
Thanks for your answers— I had forgotten about the various levels of efficient markets.

A correction means that new information suggests that the price is overinflated. Information leads to price changes. Maybe new research came from academia, maybe the CEO said something, etc.
Savvy market watchers can often calculate that assets are overinflated, and corrections confirm their suspicions. Corrections suggest inefficiency to me. I guess I just don’t buy EMH…

Buying and selling is how stock prices change. If you are buying, then overall, you have information that suggests the price is going to go even higher. Opposite for selling. Essentially, any new information becomes priced into the stock price in seconds
I’m not asking about supply and demand pressures. I’m asking about the stochastic indicators of overbought and oversold equities. They often preceed small dips and pops in an equity’s price, respectively. Perhaps EMH proponents don’t believe in such terms in the first place? Any buying or selling of an equity being done to excess would suggest an inefficiency to me.
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@cristo71
Savvy market watchers can often calculate that assets are overinflated, and corrections confirm their suspicions. Corrections suggest inefficiency to me. I guess I just don’t buy EMH…
The problem is that these calculations are already priced into the stock price. You know there was a correction after the dust has settled, not when you’re buying/selling.

Think of it from this perspective. If you thinking something is overinflated, there’s gonna be other people at the same time as you and even before you to have shorted the stock

It’s reasonable to not buy EMH for a multitude of reasons. But it is fact that active management strategies often do worse than passive strategies.

I’m not asking about supply and demand pressures. I’m asking about the stochastic indicators of overbought and oversold equities. They often preceed small dips and pops in an equity’s price, respectively. Perhaps EMH proponents don’t believe in such terms in the first place? Any buying or selling of an equity being done to excess would suggest an inefficiency to me.
Momentum is an anomaly that cannot be explained by the EMH. A key assumption of EMH is that buyers and sellers are rational. Momentum implies irrationality in the sense that you’re buying because everyone else is buying. It works out until it doesn’t.
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@ILikePie5
So EMH is just a speculative tool for predicting  stock market trends? IE looking into the future to see what commodities and services may me in short supply or vice versa and investing on those speculations? Or is it corporate purchasing of raw goods based on price speculation in the future?
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@sadolite
"This all sounds like a long winded description of supply and demand 101"

Money is a commodity. Product is a commodity. So naturally, the amount of these two should dictate their prices.

Every trade should be determined by supply of commodities and ratio of commodities on both sides.

If buyers have 6 dollars and I have 2 burgers, then ideal is that 1 burger costs 3 dollars. 6/2 = 3.

In an ideal market, this 3 dollars price is what happens. 

If burger costs more than 3 dollars, then not all burgers can be sold. (Bad for buyers) (inflation) (they cant buy enough)

If burger costs less than 3 dollars, then sellers will earn less money when they could have earned 3 dollars per burger. (Bad for sellers) (low profits) (they cant earn enough)

In an ideal market, the total sum of all prices of products is equal to the total sum of money buyers have.

This ratio in trade is the most ideal balance for both sides. It ensures all commodities are exchanged at max amount.

But this ideal trade doesnt really happen that much.

Sometimes certain amount of product is not sold at all because no one wants to buy it. In that case, the exchange is 0 for 0.

Ideally, each group of products would have same price.

Realistically, some products are overpriced while some are not even sold.

There is a battle between sellers to occupy money in buyer's wallet. There is also a battle between buyers to occupy products in seller's store.

More buyers = bad for buyers, good for sellers

More sellers = bad for sellers, good for buyers
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@ILikePie5
Think of it from this perspective. If you thinking something is overinflated, there’s gonna be other people at the same time as you and even before you to have shorted the stock
When it comes to shorting, I think of this saying:  “the market can stay irrational longer than you can stay solvent.”

I would definitely say that markets have been getting more efficient in the internet age with such fast access to current information, but I believe that people are emotional and panicky, especially when it comes to money. Yes, most money managers aren’t much better than a coin toss at making choices, but I would say that is because investing/trading is hard, not because markets are inherently efficient. The fact that some of the same people can regularly beat the market debunks EMH, IMO. There are probably numerous savvy retail investors who beat the market, too.  Retail investors aren’t held down by the same SEC rules and aren’t beholden to the emotional whims of clients they don’t have.

Is it worth all the extra effort for a small chance of achieving alpha? For the vast majority, no.
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@sadolite
So EMH is just a speculative tool for predicting  stock market trends? IE looking into the future to see what commodities and services may me in short supply or vice versa and investing on those speculations? Or is it corporate purchasing of raw goods based on price speculation in the future?
It’s a theory. EMH implies that speculation is useless because those future supply shortages are factored into the current price.
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@cristo71
When it comes to shorting, I think of this saying:  “the market can stay irrational longer than you can stay solvent.”
I agree with this for the average investor. Large hedge funds and organizations have the capital to wait it out and post margin, but the average person doesn’t.

I would definitely say that markets have been getting more efficient in the internet age with such fast access to current information, but I believe that people are emotional and panicky, especially when it comes to money.
I agree. Cognitive biases have a very large impact scientifically on human decision making. It’s why it’s hard to compare the EMH with reality. More often than not though, I would argue the EMH overpowers these biases.

Yes, most money managers aren’t much better than a coin toss at making choices, but I would say that is because investing/trading is hard, not because markets are inherently efficient.
I disagree. Most of the time active management yields less returns than passive management. Obviously there will be some who succeed like Warren Buffet, but I would argue that doesn’t violate the EMH, because reality is an apples to oranges comparison to EMH conditions.

The fact that some of the same people can regularly beat the market debunks EMH, IMO.
Read above. The second factor I would argue is luck. You can get lucky. It’s very hard to replicate your results with your strategy. It may have worked for five years, but it’s essentially like flipping a coin 5 times and getting heads 5 times. The probability is reasonable with luck.

There are probably numerous savvy retail investors who beat the market, too.  Retail investors aren’t held down by the same SEC rules and aren’t beholden to the emotional whims of clients they don’t have.
Mutual Funds and ETFs generally rely on the passive management strategy proposed by the EMH.

Is it worth all the extra effort for a small chance of achieving alpha? For the vast majority, no.
I agree. Unless you’re a hedge fund manager on Wall Street, it’s not worth it to actively manage. For everyone on this site I would recommend passively managed ETFs and Mutual Funds, while maxing out your Roth IRA every year
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Sooo supply and demand. No one can predict the future except those who have inside information and manipulate the markets/goods/services/money.
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@ILikePie5
reality is an apples to oranges comparison to EMH conditions.
I don’t get what you mean here. Aren’t we talking about reality here?

While luck certainly plays into it, there comes a point where enough time has elapsed (a decade or more) that skill, temperament, instinct, and hard work come into play…

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@cristo71
I don’t get what you mean here. Aren’t we talking about reality here?
I’m talking in the sense that the assumption that investors are rational is violated in the real world because people are dumb. In an ideal setting, arbitrage would not be possible.

We know that these exist, but the opportunities are limited and short in timing. Momentum theory in the world of EMH is an anomaly.

While luck certainly plays into it, there comes a point where enough time has elapsed (a decade or more) that skill, temperament, instinct, and hard work come into play…
Possibly, but at that point you just know how to read a room, which comes down to luck. Instinct is luck as well. There will be one person that does good for 10 years. Going back to the coin flips, getting 10 heads in a row is still a 1/1000 chance.