In the modern digital age, news and information travel as fast as it ever has. When a piece of data becomes available, it may have a quick and significant influence on the market prices of securities. Investors must wrestle with this concept when planning to make investment decisions. The burning question is - does research even matter?
It’s common to look at a number of metrics related to an investment prior to buying or selling it. These metrics include the value of certain assets and liabilities on balance sheets, profitability on income statements, and identifiable trends in the market based on technical analysis theories. Even if the metrics look good, does it necessarily mean the investment should be purchased? What if the data provided by all those metrics has already resulted in demand for the security, and thus already “baked into” the market price?
Those that believe available information is already factored into an investment’s market price are proponents of the efficient market hypothesis (EMH). This theory states available market data and information related to a security is reflected in current market prices. Data and information “efficiently” and quickly travels, and thus are priced into a security nearly instantaneously. If true, then investment research is essentially meaningless. An investor may decide a security is worthy of an investment based on their own analysis, but the EMH argues their findings already resulted in past demand for the security and will have no effect on future price movement.
Those that believe in the EMH should avoid picking specific investments in the market and shift their focus to passive investing strategies. By doing so, the investor is betting on the momentum of large segments of the market rather than picking individual securities based on their merit (which is already “baked into” the market price). Additionally, they avoid paying higher expense ratios charged by actively managed funds in order to pay their analysts for “useless” research and data.
There are three versions of EMH to be aware of:
Strong form EMH states all public and private information is reflected in the market prices of securities. While it may seem counterintuitive, even non-public inside information* is considered useless when analyzing a security. As you may already know, there is an undeniable history of investors making significant returns or avoiding large losses when illegally using inside information. Strong form EMH doesn’t necessarily disregard the history, but instead states inside information may not be as useful as it seems.
*Trading on material, non-public information, also known as inside information, is explicitly illegal. The specifics related to this concept are discussed in a future chapter.
For example, let’s assume an executive at an oil company is aware of an upcoming earnings report that will show the company’s profitability growing much more than expected. The executive assumes the stock price will rise dramatically when the information becomes public and buys a large amount of company stock just prior to the release (illegally, of course). A few days before the earnings report is released, there’s an explosion at one of the rigs owned by the oil company, resulting in a catastrophic environmental disaster. The clean-up and legal liabilities result in billions of dollars of losses. The stock price responds accordingly and plummets in the market regardless of the favorable earnings report.
In this scenario, even private insider information didn’t help the investor make a return. Strong form EMH argues circumstances like this are more prevalent and common than it may seem.
Semi-strong form EMH states all public information is reflected in the market prices of securities. This is a “step down” from strong form, which argues that non-public information can consistently predict future market movements. While scenarios like the one involving the oil company insider (above) may occur, they’re infrequent and uncommon.
Weak form EMH states most public information is reflected in the market prices of securities. Similar to semi-strong form EMH, the weak form also argues private information can consistently predict future market movements. However, it adds an extra layer of market predictability. In particular, complex fundamental analysis also offers insights into upcoming supply and demand in the market.
In the fundamental analysis chapter, we discussed the basics of balance sheets and income statements. The key word - ‘basics.’ Many analysts go through years of education and training to accurately comprehend the data provided in these complex financial documents. For example, here’s Nike’s 2021 annual report, which includes 109 pages of information related to the company’s operations and finances. Can you analyze the data provided in this report to determine the value of the company’s stock? If so, congratulations! You’re part of a small portion of investors with the skillset and experience necessary to do so.
If not, no worries! You’re like the majority of investors out there that rely on the expertise and analysis of others. This is the crux of the argument for weak form EMH. If only a small portion of investors can understand the complexities of fundamental analysis, then it’s reasonable to believe those investors may consistently predict the trajectory of market prices.
Proponents of the EMH believe future market movements are random and unpredictable. The extent of their belief depends on the EMH form they believe in:
Strong form EMH
Semi-strong form EMH
Weak form EMH
No matter the EMH form, technical analysis is not believed to consistently predict market movements. As we discussed in a previous chapter, this type of analysis assumes patterns in the market repeat themselves. This is in direct contradiction with the EMH, which states market fluctuations are random and unpredictable.
Some investors refer to the conclusions provided in EMH as part of another market theory. The random walk hypothesis states market dynamics are consistently unpredictable, and therefore all efforts to determine the quality of an investment based on available information are useless. The more an investor believes in EMH or the random walk hypothesis, the more likely they’ll engage in passive investment strategies. This applies in reverse as well - the less an investor believes in EMH or random walk hypothesis, the more likely they’ll engage in active investment strategies.
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