A Critique of Efficient Market Hypothesis

“When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rational…in fact market prices are frequently nonsensical.”

The Efficient Market Hypothesis has been praised by some security analysts as an enduring truth about financial markets. Ever since Eugene Fama coined the theory of the efficient markets in 1970, it has held a prominent position in investment theory. According to him, “in an efficient market any new information would be immediately and fully reflected in equity prices. Consequently, a financial market quickly, if not instantaneously, discounts all available information. Therefore, in an efficient market, investors should expect an asset price to reflect its true fundamental value at all times.” (Stanley & Samuelson, 2009, p.183)

Seeing the apparent logical soundness of the EMH, Michael Jensen had famously stated that “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.” (Stout, 2003, p.635) Looking back in retrospect, it is easy to see how popular the EMH had been during the middle of the century. In fact, not only did ‘market efficiency’ become a buzzword among financial analysts by the 1980s but the concept was recognized as fact even by regulators, judges and research scholars from other allied fields. (Shleifer & Summers, 1990, p.704) But the fad has faded over the last three decades.

In the article titled The Superinvestors of Graham and Doddsville, author Warren Buffett gives a classic rebuttal of the Efficient Market Hypothesis. Buffett employs wit and humour alongside statistical evidence to present arguments in support of market inefficiency. Buffett gathers the investment performance of some eminent pupils of Benjamin Graham’s school of value investing – all of whom have also worked under Graham during the 1950s. These include Walter Schloss, Tom Knapp, Ed Anderson, etc, not to mention Buffett himself. The funds conceived and run by these stalwarts is now part of investment folklore, as they managed to outperform the markets year in and year out for decades. When we compare the annual published reports of funds such as Walter J. Schloss (WJS) Ltd. Partners, Tweedy Browne Inc., Buffett Partnership Ltd, and Sequoia Fund Inc, there is compelling evidence that contradicts EMH. For example, the annualized return of WJS Ltd. Partners is an impressive 16.1%, which is double the return fetched by S&P’s Index Fund over the corresponding 28 year period. Similar anomalies to the EMH are evident in Tweedy, Browne (TBK) Inc’s returns between 1968 and 1983. In this period, TBK’s overall annual compounded rate of return stood at 16% compared to S&P’s rather modest returns of 7%. Similar divergences are seen between S&P’s annualized returns and those of funds run by Buffett Partnership Ltd., and Sequoia Fund Inc. (Buffett, 1984, p.3) Hence, it is fairly obvious to the discerning analyst that Michael Jensen’s famous 1978 proclamation doesn’t hold good anymore. The proponents of EMH have empirical evidence stacked up against them. Prominent examples are that of Warren Buffett and his guru Benjamin Graham, who have ‘beaten the market’ consistently enough to disprove the claims of the EMT.

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