Market Sense and Nonsense: How the Markets Really Work (and How They Don't)

Chapter 2

The Deficient Market Hypothesis

The most basic investment question is: Can the markets be beat? The efficient market hypothesis provides an unambiguous answer: No, unless you count those who are lucky.

The efficient market hypothesis, a theory explaining how market prices are determined and the implications of the process, has been the foundation of much of the academic research on markets and investing during the past half century. The theory underlies virtually every important aspect of investing, including risk measurement, portfolio optimization, index investing, and option pricing. The efficient market hypothesis can be summarized as follows:

• Prices of traded assets already reflect all known information.
• Asset prices instantly change to reflect new information.

Therefore,

• Market prices are true and accurate.
• It is impossible to consistently outperform the market by using any information that the market already knows.

The efficient market hypothesis comes in three basic flavors:

1. Weak efficiency. This form of the efficient market hypothesis states that past market price data cannot be used to beat the market. Translation: Technical analysis is a waste of time.

2. Semistrong efficiency (presumably named by a politician). This form of the efficient market hypothesis contends that you can’t beat the market using any publicly available information. Translation: Fundamental analysis is also a waste of time.

3. Strong efficiency. This form of the efficient market ...