efficient market hypothesis vs modern portfolio theory

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• Introduction

Diversification and the efficient frontier

Criticisms and limitations of mpt, the bottom line.

Harry Markowitz and modern portfolio theory

In the 1950s, a new crop of statisticians at Bell Laboratories , the RAND Corporation , and several universities wanted to use burgeoning computer power for analysis. They found that stock market data was comprehensive enough to analyze thoroughly, and they set off a revolution in finance.

In 1952, Harry Markowitz published a paper called “Portfolio Selection” in The Journal of Finance, setting out what he called the modern portfolio theory (MPT). It caught on, inspired other groundbreaking research, and was eventually renamed Markowitz portfolio theory in his honor. (It helped that the acronym stayed the same.) He won the Nobel Prize for his work in 1990.

• Modern portfolio theory focuses on diversification as a means to build wealth.
• The theory encourages investors to choose investments that match how much risk they’re willing to take.
• MPT helps investors build portfolios that align their savings objectives with their risk tolerance.

Whether you refer to it as Markowitz portfolio theory or modern portfolio theory, MPT introduced a systematic approach to building and managing investment portfolios. Instead of choosing individual investments, MPT urges investors to consider their risk preferences first.

At the heart of modern portfolio theory is the concept of diversification . Diversification involves spreading investments across a range of assets to reduce risk, including stocks , bonds , and alternative assets . MPT argues that by holding a well-diversified portfolio , you can achieve a more favorable risk-return trade-off than you could by concentrating your investments in a single asset or asset class .

Markowitz raised key points that continue to matter both in academic finance and the real world:

• Risk is defined in terms of standard deviations , a measure of the volatility or variability of an investment’s returns.
• Some investors are willing to accept greater risk in search of a higher return.
• Once you determine your risk tolerance , you can construct a fully diversified portfolio that optimizes the potential return for the amount of risk that you decide to take.
• Markowitz defines the efficient frontier as the highest expected return for a given level of risk , or the lowest risk for a given expected return.
• The efficient frontier illustrates the trade-offs between risk and return , helping investors identify portfolios that align with their risk tolerance and investment goals . (See figure 1.)

To determine your optimal portfolio, compare your efficient frontier arc with the capital market line (CML). This comparison illustrates the trade-off between the standard deviation (what we now call market volatility ) of returns and expected return when combining a risk-free asset (such as U.S. Treasury bonds ) with a diversified portfolio of risky assets (such as stocks and alternative investments).

The CML slopes upward because the expected return (over and above the risk-free rate) should theoretically be commensurate with the risk an investor is willing to take. The optimal portfolio, then, is the point at which your efficient frontier touches (i.e., is tangent to) the CML.

In theory: The CML helps investors determine the optimal allocation between risk-free and risky assets based on their risk preferences. The optimal portfolio is tangent to this line.

In practice: You probably won’t calculate your optimal portfolio return like this. The lesson from Markowitz that has carried into the 21st century is that investors can expect the best risk-adjusted return through diversification. That’s why index funds , which track the performance of a broad-based stock index such as the S&P 500 , can be a core component of a diversified portfolio, along with Treasuries and other fixed-income securities .

Despite its profound impact on investment practice, MPT is not without criticism. Detractors argue that the theory makes simplifying assumptions about market behavior, such as the normal distribution of asset returns and constant correlations, which may not hold in the real world.

One issue is using the standard deviation as a measure of risk. This benchmark considers a return greater than expected to be as risky as getting a return that’s less than expected, but most rational investors would disagree.

Many of the limitations reflect the revolutionary nature of Markowitz’s theory. Several economists looked at MPT, saw the benefits of the basic framework, and used it as the starting point for such fundamental financial concepts as the efficient market hypothesis (EMH) and the capital asset pricing model (CAPM). Without MPT, their work might have taken longer to emerge, if it emerged at all.

Harry Markowitz truly created modern finance, and the MPT remains the cornerstone of investment theory. The principle of managing risk preferences holds to this day. Consider two key ways to apply MPT to your investments:

• Periodically review and rebalance your portfolio so your risk preferences continue to be met. Sell assets that are overweighted (usually the assets that performed well) and use the proceeds to buy underweighted assets (usually assets that are inexpensive because they have underperformed).
• Adjust your portfolio as your risk preferences change . Early in your career, for example, you can probably take on more risk than you can later in life, as you near and enter your retirement years.

As with most investing concepts, MPT works best as a framework for understanding how the world works—theoretically (hence the name). But you must adapt the theory to your reality to find the portfolio structure that works best for you.

• Prize in Economic Sciences 1990 (press release) | nobelprize.org
• Portfolio Selection | onlinelibrary.wiley.com

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Does Modern Portfolio Theory align with EMH?

I came to the conclusion that in literature Markowitz' Portfolio Theory is believed to be compliant with the Efficient Market Hypothesis. The weakest form states that the current price fully incorporates information contained in the past history of prices only. That is, nobody can detect mispriced securities and “beat” the market by analyzing past prices.

I understand this means that future price movements are independent from what happened until now. In MPT though, to allocate funds between assets, we estimate the expected return and covariances from past prices. If we want to be compliant with EMH, shouldn't we believe that those estimates make no sense?

• modern-portfolio-theory

• 3 $\begingroup$ Hi Karol Przybylak, welcome to quant.SE! Thank you for asking your question here. $\endgroup$ –  Bob Jansen ♦ Commented Jul 20, 2014 at 7:40

4 Answers 4

EMH says that one can not earn excess return using some information. This is known as joint-hypothesis problem: to test for market efficiency one have to determine first what is "normal" market return, i.e. what type of information is normally priced by the market. Usually to test for EMH they use CAPM or 3-factor Fama-French model (which is a kind of CAPM-on-crutches), or 4-factor Carhart, of Stambaugh, of 5-factor Fama-French. CAPM, in turn, is a model for asset price in the world where everyone is using Markowitz-style optimization. Other models are built on CAPM. Authors who created it tried to overcome CAPM inconsistencies with empirical evidence.

Now back to Markowitz. Markowitz just recommends what you have to do, if you (1) want to be optimal, (2) have some expectations of return and risk. It EMH holds, your expectations wouldn't earn you excess return (but would earn you some normal). If not, then you'll earn "normal" + excess return. That's why Markowitz had won his Nobel prize: his theory is good both for efficient and non-efficient market, whatever you define "efficiency".

Now back to your question. "If we want to be compliant with EMH, shouldn't we believe that those estimates make no sense?" EMH doesn't stop you from having your own views. It just says that whatever your views would be, you can not use it and earn return in excess of return predicted by some market model (CAPM, FF3F, etc.) But if you have views, you have to organise portfolio according to Markowitz.

The weak EMH states that it is impossible to earn an excess return given publicly known information such as past prices. Clearly, different securities have different expected returns. For example: the bond and the stock of one company or a security that generates twice the return of another one.

This difference in expected return is explained by a difference in the amount of risk taken which is compensated by a risk premium. The amount of risk is persistent over time (the nature of the securities in the previous examples doesn't suddenly change), thus future price fluctuations are related to past prices. The EMH merely states that we can't predict these fluctuations better than other market participants.

The Efficient Market Hypothesis (EMH) states that you cannot beat the market on a risk-adjusted basis by looking at past prices. You can certainly earn higher returns than the market if you take on more risk (by leveraging, for example).

Modern Portfolio Theory allows you to construct portfolios that are efficient. According to this theory, you still cannot beat the market portfolio on a risk-adjusted basis.

So, using estimates with past prices with MPT does not contradict EMH.

• $\begingroup$ I agree with your answer, but could you please rephrase "better returns than the market"? I think you mean "higher" returns at the cost of more risk and lower Sharpe ratio. $\endgroup$ –  emcor Commented Jul 20, 2014 at 22:05
• $\begingroup$ Well the Sharpe ratio could be the same as the market -- it is not necessariliy lower -- but yeah higher returns for higher risk. $\endgroup$ –  SRKX Commented Jul 21, 2014 at 12:07

MPT uses expected values for its parameters.

How these expected ( future ) parameters are estimated , is another question.

Usually one takes historic averages when its the only information available, but one could for example also use analysts forecasts or other advanced estimation methods.

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What Is the Efficient Market Hypothesis?

Updated: May 11, 2022, 1:05pm

The efficient market hypothesis argues that current stock prices reflect all existing available information, making them fairly valued as they are presently. Given these assumptions, outperforming the market by stock picking or market timing is highly unlikely, unless you are an outlier who is either very lucky or very unlucky.

Understanding the Efficient Market Hypothesis

The most important assumption underlying the efficient market hypothesis is that all information relevant to stock prices is freely available and shared with all market participants.

Given the vast numbers of buyers and sellers in the market, information and data is incorporated quickly, and price movements reflect this. As a result, the theory argues that stocks always trade at their fair market value.

Followers of the efficient market hypothesis believe that if stocks always trade at their fair market value, then no level of analysis or market timing strategy will yield opportunities for outperformance.

In other words, an investor following the efficient market hypothesis shouldn’t buy undervalued stocks at bargain basement prices expecting to see large gains in the future, nor would they benefit from selling overvalued stocks.

The efficient market hypothesis begins with Eugene Fama, a University of Chicago professor and Nobel Prize winner who is regarded as the father of modern finance. In 1970, Fama published “Efficient Capital Markets: A Review of Theory and Empirical Work,” which outlined his vision of the theory.

Three Variations Of the Efficient Market Hypothesis

Investors who strongly believe in the efficient market hypothesis choose passive investment strategies that mirror benchmark performance, but they may do so to varying degrees. There are three main variations on the theory:

1. The Weak Form of the Efficient Market Hypothesis

Although investors abiding by the efficient market hypothesis believe that security prices reflect all available public market information, those following the weak form of the hypothesis assume that prices might not reflect new information that hasn’t yet been made available to the public.

It also assumes that past prices do not influence future prices, which will instead be informed by new information. If this is the case, then technical analysis is a fruitless endeavor.

The weak form of the efficient market hypothesis leaves room for a talented fundamental analyst to pick stocks that outperform in the short-term, based on their ability to predict what new information might influence prices.

2. The Semi-Strong Form of the Efficient Market Hypothesis

This form takes the same assertions of weak form, and includes the assumption that all new public information is instantly priced into the market. In this way, neither fundamental nor technical analysis can be used to generate excess returns.

3. The Strong Form of the Efficient Market Hypothesis

Strong form efficient market hypothesis followers believe that all information, both public and private, is incorporated into a security’s current price. In this way, not even insider information can give investors an opportunity for excess returns.

Arguments For and Against the Efficient Market Hypothesis

Investors who follow the efficient market hypothesis tend to stick with passive investing options, like index funds and exchange-traded funds ( ETFs ) that track benchmark indexes, for the reasons listed above.

Given the variety of investing strategies people deploy, it’s clear that not everyone believes the efficient market hypothesis to be a solid blueprint for smart investing. In fact, the investment market is teeming with mutual funds and other funds that employ active management with the goal of outperforming a benchmark index.

The Case for Active Investing

Active portfolio managers believe that they can leverage their individual skill and experience—often augmented by a team of skilled equity analysts—to exploit market inefficiencies and to generate a return that exceeds the benchmark return.

There is evidence to support both sides of the argument. The Morningstar Active vs Passive Barometer is a twice-yearly report that measures the performance of active managers against their passive peers. Nearly 3,500 funds were included in the 2020 analysis, which found that only 49% of actively managed funds outperformed their passive counterparts for the year.

On the other hand, looking at the 10-year period ending December 31, 2020 shows a different picture, since the percentage of active managers who outperformed comparable passive strategies dropped to 23%.

Are Some Markets Less Efficient than Others?

A deeper look into the Morningstar report shows that the success of active or passive management varies considerably according to the type of fund.

For example, active managers of U.S. real estate funds outperformed passively managed vehicles 62.5% of the time, but the figure drops to 25% when fees are considered.

Other areas where active management tends to outperform passive—before fees—include high yield bond funds at 59.5% and diversified emerging market funds at 58.3%. The addition of fees for portfolios that are actively managed tends to drag on their overall performance in most cases.

In other asset classes, passive managers significantly outperformed active managers. U.S. large-cap blend saw active managers outperform passive only 17.2% of the time, with the percentage dropping to 4.1% after fees.

These results seem to suggest that some markets are less efficient than others. Liquidity in emerging markets can be limited, for example, as can transparency. Political and economic uncertainty are more prevalent, and legal complexities and lack of investor protections can also cause problems.

These factors combine to create considerable inefficiencies, which a knowledgeable portfolio manager can exploit.

On the other hand, U.S. markets for large-cap or mid-cap stocks are heavily traded, and information is rapidly incorporated into stock prices. Efficiency is high and, as demonstrated by the Morningstar results, active managers have much less of an edge.

How Star Managers Handle Their Portfolios

Popular investment manager Warren Buffet is one successful example of an active investor. Buffet is a disciple of Benjamin Graham, the father of fundamental analysis, and has been a value investor throughout his career. Berkshire Hathaway, the conglomerate that holds his investments, has earned an annual return of 20% over the past 52 years, often outperforming the S&P 500 .

Another successful public investor, Peter Lynch, managed Fidelity’s Magellan Fund from 1977 to 1990. With his active investment ideology at the helm, the fund returned an average 29% annually and, over the 13-year period, Lynch outperformed the S&P 500 eleven times.

By contrast, another legendary name that stands out in the investment world is Vanguard’s Jack Bogle, the father of indexing. He believed that over the long term, investment managers could not outperform the broad market average, and high fees make such an objective even more difficult to achieve. This belief led him to create the first passively managed index fund for Vanguard in 1976.

The Efficient Market Hypothesis and Other Investment Strategies

Strong belief in the efficient market hypothesis calls into question the strategies pursued by active investors. If markets are truly efficient, investment companies are spending foolishly by richly compensating top fund managers.

The explosive growth in assets under management in index and ETF funds suggests that there are many investors who do believe in some form of the theory.

However, legions of day traders depend on technical analysis. Value managers use fundamental analysis to identify undervalued securities and there are hundreds of value funds in the U.S. alone.

These are only two examples of investors who believe that it is possible to outperform the market. With so many professional investors on each side of the efficient market hypothesis, it’s up to individual investors to weigh the evidence on both sides and to reach a conclusion about the efficiency of the financial markets that best matches their investing beliefs.

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Efficient Markets Hypothesis

The efficient market hypothesis (EMH) suggests that financial markets operate in such a way that the prices of equities, or shares in companies, are always efficient.

Elliot currently works as a Private Equity Associate at Greenridge Investment Partners, a middle market fund based in Austin, TX. He was previously an Analyst in  Piper Jaffray 's Leveraged Finance group, working across all industry verticals on  LBOs , acquisition financings, refinancings, and recapitalizations. Prior to Piper Jaffray, he spent 2 years at  Citi  in the Leveraged Finance Credit Portfolio group focused on origination and ongoing credit monitoring of outstanding loans and was also a member of the Columbia recruiting committee for the Investment Banking Division for incoming summer and full-time analysts.

Elliot has a Bachelor of Arts in Business Management from Columbia University.

• What Is The Efficient Market Hypothesis (EMH)?
• Variations Of The Efficient Markets Hypothesis
• Are Capital Markets Efficient?

What Is the Efficient Market Hypothesis (EMH)?

The efficient market hypothesis (EMH) suggests that  financial markets operate in such a way that the prices of equities, or shares in companies, are always efficient. In simpler terms, these prices accurately reflect the true value of the underlying companies they represent.

The efficient market hypothesis is one of the most foundational theories developed in finance. It was developed by Nobel laureate Eugene Fama in the 1960s and is widely known amongst finance professionals in the industry.

There are many implications arising from this hypothesis; however, the main proposition is that it is impossible to “beat the market” and generate alpha. 

What does beating the market or generating alpha mean? Broadly speaking, you can think of how much the return of your risk-adjusted investments exceeds benchmark indices. 

For example, a proxy for the US market will be the S&P 500, which covers the top 500 companies in the United States or over 80% of its total market capitalization .

If your portfolio of investments generated an alpha of 3%, then it is considered that your portfolio outperformed the S&P 500 by 3% (assuming that you trade in the US market)

How is it possible that share prices are always efficient and reflect the actual value of the underlying company following the efficient market hypothesis? 

It is because, at all times, a company's share price reflects certain relevant available information to all investors who trade upon it, and the type of information required to ensure efficient prices depends on what form of efficiency the market is in. 

If you are interested in a profession surrounding capital markets, be it asset management , sales & trading, or even hedge funds, the EMH is a theory you need to know to ace your interviews. 

However, this is only one topic in the diverse world of finance that you will truly need to know if you want to break into these careers. To gain a deeper understanding of finance, look at Wall Street Oasis's courses. For a link to our courses, click  here .

Key Takeaways

• Developed by Eugene Fama, the EMH suggests that financial markets reflect all available information and that it's impossible to consistently "beat the market" to generate abnormal returns (alpha).
• The EMH has three forms: weak, semi-strong, and strong. Each form describes the extent of information already reflected in stock prices.
• Under this form, stock prices incorporate historical information like past earnings and price movements. Investors can't gain alpha by trading on this historical data as it's already "priced in."
•  In this form, stock prices reflect all publicly available information, including recent news and announcements. Even with access to this information, investors can't consistently beat the market.
• The strongest form of EMH incorporates all information, including insider information. Even with insider knowledge, investors can't generate abnormal returns. However, some argue that real-world markets may not fully adhere to this hypothesis due to behavioral biases and inefficiencies.

Variations of the Efficient Markets Hypothesis

According to Eugene Fama, there are three variations of efficient markets:

Weak form 

Semi-strong form 

Strong form 

Depending on which form the market takes, the share price of companies incorporates different types of information. Let’s go over what kind of information is required for each form of the efficient market. 

Weak form efficiency

Under the weak form of efficient markets, share prices incorporate all historical information of stocks. This would typically cover a company’s historical earnings, price movements, technical indicators, etc. 

Another way to look at it is that when a market is weakly efficient, it means - there is no predictive power from historical information. 

Investors are unlikely to generate alpha from investing in a company just because they saw that the company outperformed earnings estimates last week. That information was already “priced in,” and there is nothing to gain trading off that information.

Semi-strong form efficiency 

The semi-strong form of efficiency within markets is believed to be most prevalent across markets. Under this form of efficiency, share prices incorporate all historical information of stocks and go a step further by including all publicly available information. 

This implies that share prices practically adjust immediately following the announcement of relevant information to a company’s stock.

What this means is that investors are not able to generate alpha by trading off relevant information that is publicly available, no matter how recent that piece of information became public.

This partially explains why you’ve probably heard those investment gurus tell you to buy the rumors and sell on the news.

One relevant example would be the reaction from every stock exchange worldwide on specific key dates surrounding the World Health Organization and the Covid-19 pandemic. 

The market crashed following specific announcements because, at that time, the market anticipated lockdowns to occur, which would damage every company’s supply chain and sales. 

If lockdowns did occur, companies wouldn’t be able to produce goods and services. Furthermore, customers wouldn’t be able to purchase goods, resulting in companies taking a hit on their earnings. And this was exactly what happened. 

Although Covid was known since November 2019, If you look at the S&P 500 and the FTSE 100, they both crashed on the same date (21st February 2020), with the impact on markets being equally significant. 

It would be safe to say that this was the date that the market started incorporating the impact of Covid-19 on a company’s share price. It is no coincidence that the World Health Organization also hosted a  press conference  that day. 

You can look at the FTSE 100 and S&P 500 index, which represent the UK and US market conditions. The following images show the drop in benchmark indices due to Covid-19: 

Unfortunately, there are a couple of caveats to this example. 

In Eugene Fama’s  purest  depiction of the semi-strong form of an efficient market hypothesis, prices are meant to adjust instantaneously following the public announcement of relevant information, with the new prices reflecting the market’s new actual value. 

When you look at the market’s reaction to Covid-19, the market crash happened gradually over a certain period. 

Furthermore, if you look at the FTSE 100 and S&P 500, the index started showing signs of recovery immediately after the market crash. 

Broadly speaking, there are two reasons this could have happened: 

There was an announcement of new publicly available information with a positive impact on markets

The market had initially overreacted to the Covid-19 pandemic

An excellent example of newly announced publicly available information with a positive impact on markets would be something like the respective countries’ governments and central banks both promoting aggressive monetary and fiscal policies designed to improve economic situations. 

Although it is impossible to say, and every investor will have a different opinion on the market, the consensus is that the market has reacted to monetary and fiscal policies. As a result, there was an initial overreaction to Covid-19 in the market. 

This is where the practical example strays away from theory. In the market’s reaction to Covid-19, the impact of new information was gradual (but still quick) and argued to be inefficient at the trough. 

However, Eugene Fama’s efficient market hypothesis anticipates rapid price movements following the release of public information, and prices are always efficient, moving from one true value to another. 

Market indices that genuinely follow the semi-strong form efficient market hypothesis would look something like this: 

And this is what the  true  efficient market hypothesis envisions. There is no exaggeration in this graph, and the market index isn't expected to have any daily fluctuation because it reflects the valid, efficient value pricing in all the publicly available information. 

Reaction to new relevant information is instant and accurate, leaving no room for values to readjust over time. 

This example applies to all forms of efficient markets, including the weak and strong forms. However, the difference is the type of information that will cause a company's share price to readjust. 

Strong form efficiency 

The share prices of companies in strongly efficient markets incorporate everything that the semi-strong form efficiency incorporates but go a step further by also incorporating insider information. 

This implies that investors who know something about a company that isn't publicly known cannot generate abnormal returns trading off that information.

Generally speaking, you should expect more developed countries to have more efficient markets, mainly because more asset managers are analyzing stocks and more educated individuals make better investment decisions.

However, if any country were likely to display powerfully efficient markets, you would expect them to exist within more corrupt and opaque countries. This is because countries like the US and UK have implemented sanctions against insider trading purely because of how profitable it is. 

Investors with insider information are known to have an edge in markets, which is why there are policies in place dictating that asset managers and substantial shareholders must disclose their trades to the Securities and Exchange Commission ( SEC ). 

Under  Rule 10b-5 , the SEC explicitly states that insiders are prohibited from trading on material non-public information. 

In November 2021, a  McKinsey partner was charged with insider trading  because he assisted Goldman Sachs with its acquisition of GreenSky. 

The Mckinsey partner had private information regarding the GreenSky acquisition and purchased multiple call options on GreenSky, profiting over $450,000. 

Aside from the fact that the man was blatantly insider trading, the fact that he was able to profit off insider information is evidence that the US market does  NOT  possess strong form efficiency.

The above is somewhat considered to be proof by contradiction. If markets were efficient, trading off insider information would not let investors generate abnormal returns. But in this case, the Mckinsey partner could make almost half a million dollars!

To put that into perspective, $450 thousand is more than two years of the average investment banking analyst’s total compensation and slightly over four years of base pay. 

Are capital markets efficient?

After developing a decent understanding of the efficient market hypothesis, the real question is: is the market truly efficient, and do they follow the EMH? This topic is controversial, and many individuals will support different sides of the argument. 

Supporters of the efficient market hypothesis generally believe in traditional neoclassical finance. Neoclassical finance has been around since the twentieth century, and its approach revolves around key assumptions like perfect knowledge or rationality among individuals. 

In fact, most of the material taught at university and in textbooks are materials that talk about neoclassical finance - one might argue that the world of finance was built by theories such as the EMH. 

However, some of the assumptions in neoclassical finance have always been known to be overly restrictive and not at all realistic. For example, humans are not the objective supercomputers that neoclassical finance believes us to be. 

The fact is that humans are ruled by emotions and subjected to behavioral biases. We do not act the same as everyone else, and it is absurd to believe that we all behave rationally or even have perfect knowledge about a subject before making decisions.

Some of the latest developments in academics have been surrounding behavioral finance, with Nobel laureates including Robert Shiller and Richard Thaler (cameo in a classic finance film titled The Big Short) leading the field and relaxing unrealistic assumptions in neoclassical finance. 

Aside from being unable to generate alpha, another significant implication arising from the EMH is that investors can blindly purchase any stock in the exchange without any prior analysis and still receive a fair return on equity . 

That does not make sense because if everyone did that, then it would be safe to assume that the share prices would be wildly inaccurate and far apart from the company’s actual value. 

The fact is that there is some reliance upon financial institutions such as asset managers or arbitrageurs to constantly monitor and exploit inefficiencies within capital markets (such as buying underpriced and shorting overpriced equities) to keep the market efficient. 

Therefore, another argument arising from this is the idea that markets are efficiently inefficient where money managers who use costly financial information software such as Bloomberg Terminal or FactSet can gain a competitive edge in the market.

These money managers generate abnormal returns by exploiting inefficiencies within markets, such as longing for undervalued stocks or shorting overvalued stocks. A beneficial outcome of this activity is that market prices are slowly shifting towards efficient values.

The biggest argument supporting the efficient market hypothesis is that many money managers cannot outperform benchmark indices such as the S&P 500 on a year-to-year basis.

That argument is further supported when you compare the average 20-year annual return of the S&P 500 to any hedge fund’s average 20-year yearly return. You will find that  MOST  money managers underperform compared to the benchmark. 

The table below displays the November 2021 return of the top hedge funds. For reference, the S&P 500 had a total return of  26.89% . 

Therefore, if you compare the hedge funds to the S&P 500 (ignoring the hedge funds’ December 2021 performance), you can see that only three hedge funds outperformed the index. 

Hedge funds are also costly, with many institutions imposing a minimum 2-20 fee structure where there is a 2% fee charged on the AUM of the fund and a 20% fee for any profit above the hurdle rate. 

Nevertheless, while the data seems to point to the fact that hedge funds can be somewhat lackluster, a common argument is that the concept of a hedge fund is to “hedge,” which means to protect money. 

Therefore, perhaps some hedge funds have a greater purpose of maintaining their AUM rather than growing it despite the fact that hedge funds are known for having the most aggressive investment strategies . 

Overall, being a part of a hedge fund is still highly lucrative. For example, Kenneth Griffin, CEO of Citadel LLC, had total compensation of over $2 billion in 2021, whereas David Solomon, CEO of Goldman Sachs, had a total payment of $35 million in 2021. 

If you want to make $2 billion a year in a hedge fund one day, you need to polish up your interviewing skills. To impress your interviewers, look at Wall Street Oasis’s Hedge Fund Interview Prep Course . For a link to our courses, click  here .

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• Efficient Market Theory

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on June 08, 2023

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Table of contents, what is efficient market theory (emt).

Efficient market theory (EMT) is a concept in finance that asserts that financial markets are highly efficient and that prices of assets fully reflect all available information.

EMT has been a prominent topic of debate among finance academics and practitioners since its inception.

It has been a widely studied and researched topic for decades, and its applications have had significant implications for investment decision-making, portfolio management, and market regulation.

The concept of EMT has its roots in the works of Eugene Fama , who introduced it in 1965.

EMT is grounded in the notion that market participants are rational and have access to all relevant information.

Therefore, in an efficient market, prices of securities are determined by market forces, and any new information is immediately incorporated into prices.

This implies that it is impossible to outperform the market consistently, as prices already reflect all available information.

Forms of Efficient Market Theory

EMT is commonly categorized into three forms, which include the weak form, semi-strong form, and strong form.

Weak Form: The weak form of EMT asserts that all past prices of securities are reflected in current prices, and it is impossible to use past prices to predict future prices.

Semi-strong Form: The semi-strong form of EMT suggests that current prices reflect all publicly available information, including financial statements and other disclosures.

Strong Form: The strong form of EMT suggests that current prices reflect all available information, including public and private information. In this case, insider trading would not be profitable, as prices already reflect all available information.

Empirical Evidence in Support of Efficient Market Theory

Numerous empirical studies have been conducted to test the validity of EMT.

Stock Prices Follow Random Pattern

One of the earliest and most influential studies was conducted by Fama himself. In his study, he found that stock prices in the United States followed a random walk pattern and were not predictable.

Market Prices Are Unpredictable

Other studies have found similar results, suggesting that market prices are unpredictable and follow a random walk pattern.

Actively Managed Funds Underperform

In addition, some studies have found that actively managed funds, which seek to outperform the market, often underperform the market after accounting for fees and transaction costs.

Criticisms of Efficient Market Theory

Despite the empirical evidence in support of EMT, there are several criticisms of the theory.

Investors Are Not Rational

Another criticism is that EMT assumes that all market participants are rational and have access to all relevant information. In reality, investors may not be rational, and access to information may be limited or biased.

Reflected Market Prices Are Not Always Correct

This assumption implies that the market always incorporates all relevant information into prices, which critics argue may not be true due to behavioral biases and other external factors that can impact market prices.

Prices Are Influenced by External Factors

Prices can be influenced by irrational market behavior or by external factors such as political events or natural disasters.

Behavioral Finance and Efficient Market Theory

Behavioral finance is a field of study that seeks to understand how psychological factors influence investor behavior and market outcomes.

Behavioral finance suggests that investors are not always rational and that market prices may not always reflect all available information. Therefore, behavioral finance challenges the underlying assumptions of EMT.

Behavioral finance has identified several cognitive biases that can influence investor behavior, such as overconfidence, herd mentality, and loss aversion. These biases can lead to market inefficiencies and opportunities for skilled investors to outperform the market.

Implications of Efficient Market Theory

The implications of EMT are far-reaching and have significant implications on the following:

Portfolio Management

EMT suggests that it is impossible to outperform the market consistently, and as such, active portfolio management strategies, such as stock picking and market timing are unlikely to be successful in the long run.

Instead, EMT suggests that investors should focus on passive investment strategies such as index funds that aim to replicate market performance.

Market Regulation

The implications of EMT for market regulation are also significant. If prices are always efficient, then it may not be necessary to regulate markets to ensure that prices are fair.

However, some argue that regulation is still necessary to prevent fraud and market manipulation, which can lead to market inefficiencies and undermine investor confidence.

Alternatives to Efficient Market Theory

There are several alternative theories and perspectives to EMT:

Technical Analysis

A popular approach to investing that involves analyzing past market data, such as price and volume, to predict future price movements.

Fundamental Analysis

This involves analyzing a company's financial statements, industry trends, and macroeconomic factors to determine its intrinsic value .

Value Investing

This strategy involves identifying undervalued securities and investing in them with the expectation that their value will increase over time.

Final Thoughts

Efficient Market Theory is a cornerstone of financial economics, positing that financial markets are efficient and that asset prices reflect all available information.

The concept has significant implications for investment decision-making, portfolio management, and market regulation.

However, the debate surrounding EMT remains ongoing, with some scholars pointing to empirical evidence that supports the theory while others criticize its underlying assumptions.

Despite the criticisms, the concept of EMT continues to be relevant in financial markets today. Investors must carefully consider the underlying assumptions of the theory and alternative approaches to investing when making investment decisions.

Understanding the implications of EMT for investment decision-making, portfolio management, and market regulation is critical to success in today's financial markets.

While EMT has limitations, it remains a valuable tool for understanding the behavior of financial markets and the pricing of financial assets. For more information on efficient market theory and support in applying it to your circumstances, you may consult a wealth management professional.

Efficient Market Theory FAQs

What is efficient market theory.

Efficient market theory is a concept in finance that asserts that financial markets are highly efficient and that prices of assets fully reflect all available information.

What are the forms of efficient market theory?

Is there empirical evidence to support efficient market theory.

Numerous empirical studies have been conducted to test the validity of EMT. Some studies have found evidence in support of EMT, while others have found evidence that contradicts the theory.

What are the criticisms of efficient market theory?

The criticisms of EMT center around the difficulty in defining what constitutes relevant information, the assumption that all market participants are rational and have access to all relevant information, and the assumption that market prices are always correct.

What are the implications of efficient market theory for investment decision-making?

EMT suggests that it is impossible to outperform the market consistently, and as such, active portfolio management strategies such as stock picking and market timing are unlikely to be successful in the long run. Instead, EMT suggests that investors should focus on passive investment strategies, such as index funds that aim to replicate market performance.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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What is the Efficient Markets Hypothesis?

• Understanding the Efficient Markets Hypothesis
• Variations of the Efficient Markets Hypothesis

Arguments For and Against the EMH

Impact of the emh, related readings, efficient markets hypothesis.

"It is not possible to outperform the market by skill alone"

The Efficient Markets Hypothesis (EMH) is an investment theory primarily derived from concepts attributed to Eugene Fama’s research as detailed in his 1970 book, “Efficient Capital Markets: A Review of Theory and Empirical Work.” Fama put forth the basic idea that it is virtually impossible to consistently “beat the market” – to make investment returns that outperform the overall market average as reflected by major stock indexes such as the S&P 500 Index .

According to Fama’s theory, while an investor might get lucky and buy a stock that brings him huge short-term profits, over the long term he cannot realistically hope to achieve a return on investment that is substantially higher than the market average.

Understanding the Efficient Markets Hypothesis

Fama’s investment theory – which carries essentially the same implication for investors as the Random Walk Theory – is based on a number of assumptions about securities markets and how they function. The assumptions include the one idea critical to the validity of the efficient markets hypothesis: the belief that all information relevant to stock prices is freely and widely available, “universally shared” among all investors.

As there are always a large number of both buyers and sellers in the market, price movements always occur efficiently (i.e., in a timely, up-to-date manner). Thus, stocks are always trading at their current fair market value.

The major conclusion of the theory is that since stocks always trade at their fair market value , then it is virtually impossible to either buy undervalued stocks at a bargain or sell overvalued stocks for extra profits. Neither expert stock analysis nor carefully implemented market timing strategies can hope to average doing any better than the performance of the overall market. If that’s true, then the only way investors can generate superior returns is by taking on much greater risk.

Variations of the Efficient Markets Hypothesis

There are three variations of the hypothesis – the weak , semi-strong , and strong forms – which represent three different assumed levels of market efficiency.

1. Weak Form

The weak form of the EMH assumes that the prices of securities reflect all available public market information but may not reflect new information that is not yet publicly available. It additionally assumes that past information regarding price, volume, and returns is independent of future prices.

The weak form EMH implies that technical trading strategies cannot provide consistent excess returns because past price performance can’t predict future price action that will be based on new information. The weak form, while it discounts technical analysis, leaves open the possibility that superior fundamental analysis may provide a means of outperforming the overall market average return on investment.

2. Semi-strong Form

The semi-strong form of the theory dismisses the usefulness of both technical and fundamental analysis. The semi-strong form of the EMH incorporates the weak form assumptions and expands on this by assuming that prices adjust quickly to any new public information that becomes available, therefore rendering fundamental analysis incapable of having any predictive power about future price movements. For example, when the monthly Non-farm Payroll Report in the U.S. is released each month, you can see prices rapidly adjusting as the market takes in the new information.

3. Strong Form

The strong form of the EMH holds that prices always reflect the entirety of both public and private information. This includes all publicly available information, both historical and new, or current, as well as insider information. Even information not publicly available to investors, such as private information known only to a company’s CEO, is assumed to be always already factored into the company’s current stock price.

So, according to the strong form of the EMH, not even insider knowledge can give investors a predictive edge that will enable them to consistently generate returns that outperform the overall market average.

Supporters and opponents of the efficient markets hypothesis can both make a case to support their views. Supporters of the EMH often argue their case based either on the basic logic of the theory or on a number of studies that have been done that seem to support it.

A long-term study by Morningstar found that, over a 10-year span of time, the only types of actively managed funds that were able to outperform index funds even half of the time were U.S. small growth funds and emerging markets funds. Other studies have revealed that less than one in four of even the best-performing active fund managers prove capable of outperforming index funds on a consistent basis.

Note that such data calls into question the whole investment advisory business model that has investment companies paying out huge amounts of money to top fund managers, based on the belief that those money managers will be able to generate returns well above the average overall market return.

Opponents of the efficient markets hypothesis advance the simple fact that there ARE traders and investors – people such as John Templeton, Peter Lynch, and Paul Tudor Jones – who DO consistently, year in and year out, generate returns on investment that dwarf the performance of the overall market. According to the EMH, that should be impossible other than by blind luck. However, blind luck can’t explain the same people beating the market by a wide margin, over and over again. over a long span of time.

In addition, those who argue that the EMH theory is not a valid one point out that there are indeed times when excessive optimism or pessimism in the markets drives prices to trade at excessively high or low prices, clearly showing that securities, in fact, do not always trade at their fair market value.

The significant rise in the popularity of index funds that track major market indexes – both mutual funds and ETFs – is due, at least in part, to widespread popular acceptance of the efficient markets hypothesis. Investors who subscribe to the EMH are more inclined to invest in passive index funds that are designed to mirror the market’s overall performance, and less inclined to be willing to pay high fees for expert fund management when they don’t expect even the best of fund managers to significantly outperform average market returns.

On the other hand, because research in support of the EMH has shown just how rare money managers can consistently outperform the market, the few individuals who have developed such a skill are ever more sought after and respected.

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• Modern Portfolio Theory

Enter Behavioral Finance

Market efficiency, knowledge distribution, rational investment decisions, the bottom line.

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Modern Portfolio Theory vs. Behavioral Finance

Modern portfolio theory (MPT) and behavioral finance represent differing schools of thought that attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and positions is to think of modern portfolio theory as how the financial markets would work in the ideal world, and to think of behavioral finance as how financial markets work in the real world. Having a solid understanding of both theory and reality can help you make better investment decisions.

Key Takeaways

• Evaluating how people should invest (i.e., portfolio choice) has been an important project undertaken by economists and investors alike.
• Modern portfolio theory is a prescriptive theoretical model that shows what asset class mix would produce the greatest expected return for a given risk level.
• Behavioral finance instead focuses on correcting for the cognitive and emotional biases that prevent people from acting rationally in the real world.

Modern Portfolio Theory

Modern portfolio theory is the basis for much of the conventional wisdom that underpins investment decision making. Many core points of modern portfolio theory were captured in the 1950s and1960s by the efficient market hypothesis put forth by Eugene Fama of the University of Chicago.

According to Fama’s theory, financial markets are efficient, investors make rational decisions, market participants are sophisticated, informed and act only on available information. Since everyone has the same access to that information, all securities are appropriately priced at any given time. If markets are efficient and current, it means that prices always reflect all information, so there's no way you'll ever be able to buy a stock at a bargain price.

Other snippets of conventional wisdom include the theory that the stock market will return an average of 8% per year (which will result in the value of an investment portfolio doubling every nine years), and that the ultimate goal of investing is to beat a static benchmark index. In theory, it all sounds good. The reality can be a bit different.

Modern portfolio theory (MPT) was developed by Harry Markowitz during the same period to identify how a rational actor would construct a diversified portfolio across several asset classes in order to maximize expected return for a given level of risk preference. The resulting theory constructed an " efficient frontier ," or the best possible portfolio mix for any risk tolerance. Modern portfolio theory then uses this theoretical limit to identify optimal portfolios through a process of mean-variance optimization (MVO).

Image by Sabrina Jiang © Investopedia 2021

Despite the nice, neat theories, stocks often trade at unjustified prices, investors make irrational decisions , and you would be hard-pressed to find anyone who owns the much-touted “average” portfolio generating an 8% return every year like clockwork.

So what does all of this mean to you? It means that emotion and psychology play a role when investors make decisions, sometimes causing them to behave in unpredictable or irrational ways. This is not to say that theories have no value, as their concepts do work—sometimes.

Perhaps the best way to consider the differences between theoretical and behavioral finance is to view the theory as a framework from which to develop an understanding of the topics at hand, and to view the behavioral aspects as a reminder that theories don’t always work out as expected. Accordingly, having a good background in both perspectives can help you make better decisions. Comparing and contrasting some of the major topics will help set the stage.

The idea that financial markets are efficient is one of the core tenets of modern portfolio theory. This concept, championed in the efficient market hypothesis, suggests that at any given time prices fully reflect all available information on a particular stock and/or market. Since all market participants are privy to the same information, no one will have an advantage in predicting a return on a stock price because no one has access to better information.

In efficient markets, prices become unpredictable, so no investment pattern can be discerned, completely negating any planned approach to investing. On the other hand, studies in  behavioral finance , which look into the effects of investor psychology on stock prices, reveal some predictable patterns in the stock market.

In theory, all information is distributed equally. In reality, if this was true, insider trading would not exist. Surprise bankruptcies would never happen. The  Sarbanes-Oxley Act of 2002 , which was designed to move the markets to greater levels of efficiency because the access to information for certain parties was not being fairly disseminated, would not have been necessary.

And let’s not forget that personal preference and personal ability also play roles. If you choose not to engage in the type of research conducted by Wall Street stock analysts , perhaps because you have a job or a family and don’t have the time or the skills, your knowledge will certainly be surpassed by others in the marketplace who are paid to spend all day researching securities. Clearly, there is a disconnect between theory and reality.

Theoretically, all investors make rational investment decisions. Of course, if everyone was rational there would be no speculation, no bubbles and no irrational exuberance . Similarly, nobody would buy securities when the price was high and then panic and sell when the price drops.

Theory aside, we all know that speculation takes place and that bubbles develop and pop. Furthermore, decades of research from organizations such as Dalbar, with its Quantitative Analysis of Investor Behavior study, show that irrational behavior plays a big role and costs investors dearly.

While it is important to study the theories of efficiency and review the empirical studies that lend them credibility, in reality, markets are full of inefficiencies. One reason for the inefficiencies is that every investor has a unique investment style and way of evaluating an investment. One may use technical strategies while others rely on fundamentals, and still others may resort to using a dartboard.

Many other factors influence the price of investments, ranging from emotional attachment, rumors and the price of the security to good old supply and demand . Clearly, not all market participants are sophisticated, informed and act only on available information. But understanding what the experts expect— and  how other market participants may act—will help you make good investment decisions for your portfolio and prepare you for the market’s reaction when others make their decisions.

Knowing that markets will fall for unexpected reasons and rise suddenly in response to unusual activity can prepare you to ride out the volatility without making trades you will later regret. Understanding that stock prices can move with “the herd” as investor buying behavior pushes prices to unattainable levels can stop you from buying those overpriced technology shares.

Similarly, you can avoid dumping an oversold but still valuable stock when investors rush for the exits.

Education can be put to work on behalf of your portfolio in a logical way, yet with your eyes wide open to the degree of illogical factors that influence not only investors' actions, but security prices as well. By paying attention, learning the theories , understanding the realities and applying the lessons, you can make the most of the bodies of knowledge that surround both traditional financial theory and behavioral finance.

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The Efficient Market Hypothesists

Bachelier, Samuelson, Fama, Ross, Tobin and Shiller

• © 2013

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Market Efficiency Hypothesis

Table of contents (33 chapters)

Front matter, introduction, louis bachelier: the first physicist financial theorist, the early years, discussion and applications: einstein and bachelier, life and legacy, paul samuelson’s random walk, discussion and applications, the nobel prize, life, and legacy, eugene fama’s efficient market hypothesis, about the author, bibliographic information.

Book Title : The Efficient Market Hypothesists

Book Subtitle : Bachelier, Samuelson, Fama, Ross, Tobin and Shiller

Authors : Colin Read

Series Title : Great Minds in Finance

DOI : https://doi.org/10.1057/9781137292216

Publisher : Palgrave Macmillan London

eBook Packages : Palgrave Economics & Finance Collection , Economics and Finance (R0)

Copyright Information : Palgrave Macmillan, a division of Macmillan Publishers Limited 2013

Hardcover ISBN : 978-0-230-27421-1 Published: 15 December 2012

Softcover ISBN : 978-1-349-32435-4 Published: 01 January 2013

eBook ISBN : 978-1-137-29221-6 Published: 26 December 2015

Series ISSN : 2947-8987

Series E-ISSN : 2947-8995

Edition Number : 1

Number of Pages : IX, 222

Topics : Financial History , European History , Accounting/Auditing , Business Finance , Economics, general , Banking

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