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market equilibrium, efficient informational gathering activity should be fruitful.1 Moreover, it
would not be surprising to find that the degree of efficiency across various markets may dif-
fer. For example, emerging markets, which are less intensively analyzed than U.S. markets
and in which information is harder to come by, may be less efficient than U.S. markets. Small
stocks, which receive less coverage by Wall Street analysts, may be less efficiently priced than
large ones. Still, while we would not go so far as to say you absolutely cannot come up with
new information, it makes sense to consider and respect your competition.
Assume an investment management firm is managing a $5 billion portfolio. Suppose the
fund manager can devise a research program that could increase the portfolio rate of return by
one-tenth of 1% per year, a seemingly modest amount. This program would increase the dol-
lar return to the portfolio by $5 billion .001, or $5 million. Therefore, the fund is presum-
ably willing to spend up to $5 million per year on research to increase stock returns by a mere
one-tenth of 1% per year.
With such large rewards for such small increases in investment performance, is it any sur-
prise that professional portfolio managers are willing to spend large sums on industry analysts,
computer support, and research effort? With so many well-backed analysts willing to spend con-
siderable resources on research, there cannot be many easy pickings in the market. Moreover,
the incremental rates of return on research activity are likely to be so small that only managers
of the largest portfolios will find them worth pursuing.
While it may not literally be true that all relevant information will be uncovered, it is vir-
tually certain there are many investigators hot on the trail of any leads that seem likely to im-
prove investment performance. Competition among these many well-backed, highly paid,
aggressive analysts ensures that, as a general rule, stock prices ought to reflect available in-
formation regarding their proper levels.

A challenging and insightful discussion of this point may be found in Sanford J. Grossman and Joseph E. Stiglitz,
“On the Impossibility of Informationally Efficient Markets,” American Economic Review 70 (June 1980).
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8 The Efficient Market Hypothesis

Versions of the Efficient Market Hypothesis
It is common to distinguish among three versions of the EMH: the weak, the semistrong, and
the strong forms of the hypothesis. These versions differ according to their notions of what is
meant by the term all available information.
The weak-form EMH asserts that stock prices already reflect all information that can be weak-form EMH
derived by examining market trading data such as the history of past prices, trading volume, The assertion that
or short interest. This version of the hypothesis implies that trend analysis is fruitless. Past stock prices already
stock price data are publicly available and virtually costless to obtain. The weak-form hy- reflect all information
contained in the
pothesis holds that if such data ever conveyed reliable signals about future performance, all
history of past
investors would have learned long since to exploit the signals. Ultimately, the signals lose
their value as they become widely known, because a buy signal, for instance, would result in
an immediate price increase.
The semistrong-form EMH states that all publicly available information regarding the semistrong-
prospects of a firm must be already reflected in the stock price. Such information includes, in form EMH
addition to past prices, fundamental data on the firm™s product line, quality of management, The assertion that
balance sheet composition, patents held, earnings forecasts, accounting practices, and so forth. stock prices already
Again, if any investor has access to such information from publicly available sources, one reflect all publicly
available information.
would expect it to be reflected in stock prices.
Finally, the strong-form EMH states that stock prices reflect all information relevant to
strong-form EMH
the firm, even including information available only to company insiders. This version of the
hypothesis is quite extreme. Few would argue with the proposition that corporate officers The assertion that
have access to pertinent information long enough before public release to enable them to stock prices reflect all
relevant information,
profit from trading on that information. Indeed, much of the activity of the Securities and
including inside
Exchange Commission (SEC) is directed toward preventing insiders from profiting by ex-
ploiting their privileged situation. Rule 10b-5 of the Security Exchange Act of 1934 limits
trading by corporate officers, directors, and substantial owners, requiring them to report
trades to the SEC. Anyone trading on information supplied by insiders is considered in vio-
lation of the law.
Defining insider trading is not always easy, however. After all, stock analysts are in the
business of uncovering information not already widely known to market participants. As we
saw in Chapter 3, the distinction between private and inside information is sometimes murky.

1. a. Suppose you observed that high-level managers were making superior returns Concept
on investments in their company™s stock. Would this be a violation of weak-
form market efficiency? Would it be a violation of strong-form market
b. If the weak form of the efficient market hypothesis is valid, must the strong
form also hold? Conversely, does strong-form efficiency imply weak-form

8.2 IMPLICATIONS OF THE EMH technical analysis
Research on recurrent
Technical Analysis and predictable stock
price patterns and on
Technical analysis is essentially the search for recurring and predictable patterns in stock prices. proxies for buy or sell
Although technicians recognize the value of information that has to do with future economic pressure in the
prospects of the firm, they believe such information is not necessary for a successful trading market.
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266 Part TWO Portfolio Theory

strategy. Whatever the fundamental reason for a change in stock price, if the stock price responds
slowly enough, the analyst will be able to identify a trend that can be exploited during the ad-
justment period. Technical analysis assumes a sluggish response of stock prices to fundamental
supply and demand factors. This assumption is diametrically opposed to the notion of an effi-
cient market.
Technical analysts sometimes are called chartists because they study records or charts
of past stock prices, hoping to find patterns they can exploit to make a profit. As an exam-
ple of technical analysis, consider the relative strength approach. The chartist compares
stock performance over a recent period to performance of the market or other stocks in the
same industry. A simple version of relative strength takes the ratio of the stock price to a
market indicator such as the S&P 500 index. If the ratio increases over time, the stock is
said to exhibit relative strength, because its price performance is better than that of the
broad market. Such strength presumably may continue for a long enough period to offer
profit opportunities.
The efficient market hypothesis predicts that technical analysis is without merit. The past
history of prices and trading volume is publicly available at minimal cost. Therefore, any in-
formation that was ever available from analyzing past prices has already been reflected in
stock prices. As investors compete to exploit their common knowledge of a stock™s price his-
tory, they necessarily drive stock prices to levels where expected rates of return are commen-
surate with risk. At those levels, stocks are neither bad nor good buys. They are just fairly
priced, meaning one should not expect abnormal returns.
Despite these theoretical considerations, some technically oriented trading strategies would
have generated abnormal profits in the past. We will consider these strategies, and technical
analysis more generally in Chapter 19.

Fundamental Analysis
Fundamental analysis uses earnings and dividend prospects of the firm, expectations of fu-
ture interest rates, and risk evaluation of the firm to determine proper stock prices. Ultimately,
it represents an attempt to determine the present discounted value of all the payments a stock-
Research on
holder will receive from each share of stock. If that value exceeds the stock price, the funda-
determinants of
mental analyst would recommend purchasing the stock.
stock value, such as
earnings and Fundamental analysts usually start with a study of past earnings and an examination of
dividends prospects, company financial statements. They supplement this analysis with further detailed economic
expectations for
analysis, ordinarily including an evaluation of the quality of the firm™s management, the firm™s
future interest rates,
standing within its industry, and the prospects for the industry as a whole. The hope is to at-
and risk of the firm.
tain some insight into the future performance of the firm that is not yet recognized by the rest
of the market. Chapters 11 to 13 provide a detailed discussion of the types of analyses that un-
derlie fundamental analysis.
Once again, the efficient market hypothesis predicts that most fundamental analysis will
add little value. If analysts rely on publicly available earnings and industry information, one
analyst™s evaluation of the firm™s prospects is not likely to be significantly more accurate than
another™s. There are many well-informed, well-financed firms conducting such market re-
search, and in the face of such competition, it will be difficult to uncover data not also avail-
able to other analysts. Only analysts with a unique insight will be rewarded.
Fundamental analysis is much more difficult than merely identifying well-run firms with
good prospects. Discovery of good firms does an investor no good in and of itself if the rest
of the market also knows those firms are good. If the knowledge is already public, the in-
vestor will be forced to pay a high price for those firms and will not realize a superior rate
of return.
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Essentials of Investments, Hypothesis Companies, 2003
Fifth Edition

8 The Efficient Market Hypothesis

The trick is not to identify firms that are good, but to find firms that are better than every-
one else™s estimate. Similarly, poorly run firms can be great bargains if they are not quite as
bad as their stock prices suggest.
This is why fundamental analysis is difficult. It is not enough to do a good analysis of a
firm; you can make money only if your analysis is better than that of your competitors because
the market price is expected to already reflect all commonly available information.

Active versus Passive Portfolio Management
Casual efforts to pick stocks are not likely to pay off. Competition among investors ensures
that any easily implemented stock evaluation technique will be used widely enough so that
any insights derived will be reflected in stock prices. Only serious analyses and uncommon
techniques are likely to generate the differential insight necessary to generate trading profits.
Moreover, these techniques are economically feasible only for managers of large portfolios.
If you have only $100,000 to invest, even a 1% per year improvement in performance gener-
ates only $1,000 per year, hardly enough to justify herculean efforts. The billion-dollar man-
ager, however, would reap extra income of $10 million annually for the same 1% increment.
If small investors are not in a favored position to conduct active portfolio management,
what are their choices? The small investor probably is better off placing funds in a mutual
fund. By pooling resources in this way, small investors can obtain the advantages of large size.
More difficult decisions remain, though. Can investors be sure that even large mutual funds
have the ability or resources to uncover mispriced stocks? Further, will any mispricing un-
covered be sufficiently large to repay the costs entailed in active portfolio management?
Proponents of the efficient market hypothesis believe active management is largely wasted
effort and unlikely to justify the expenses incurred. Therefore, they advocate a passive in- passive
vestment strategy that makes no attempt to outsmart the market. A passive strategy aims only investment
at establishing a well-diversified portfolio of securities without attempting to find under- or strategy
overvalued stocks. Passive management usually is characterized by a buy-and-hold strategy. Buying a well-
Because the efficient market theory indicates stock prices are at fair levels, given all available diversified portfolio
information, it makes no sense to buy and sell securities frequently, as transactions generate without attempting to
search out mispriced
large trading costs without increasing expected performance.
One common strategy for passive management is to create an index fund, which is a fund
designed to replicate the performance of a broad-based index of stocks. For example, in 1976,
index fund
the Vanguard Group of mutual funds introduced a mutual fund called the Index 500 Portfolio
that holds stocks in direct proportion to their weight in the Standard & Poor™s 500 stock price A mutual fund
holding shares in
index. The performance of the Index 500 fund replicates the performance of the S&P 500. In-
proportion to their
vestors in this fund obtain broad diversification with relatively low management fees. The fees
representation in a
can be kept to a minimum because Vanguard does not need to pay analysts to assess stock market index such as
prospects and does not incur transaction costs from high portfolio turnover. While the typical the S&P 500.
annual expense ratio for an actively managed fund is over 1% of assets, Vanguard charges less
than 0.2% for the Index 500 Portfolio.
Indexing has grown in appeal considerably since 1976. Vanguard™s Index 500 Portfolio was
the largest mutual fund in August 2002, with $86 billion in assets. Several other firms have
introduced S&P 500 index funds but Vanguard still dominates the retail market for indexing.
Including pension funds and mutual funds, more than $1 trillion was indexed to the S&P 500
by early 2001. Many institutional investors now hold indexed bond portfolios as well as in-
dexed stock portfolios.
Mutual funds now offer indexed portfolios that match a wide variety of market indexes.
For example, some of the funds offered by the Vanguard Group track the S&P 500 Index,
the Wilshire 5000 Index, the Lehman Brothers Aggregate Bond Index, the Russell 2000
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268 Part TWO Portfolio Theory

index of small capitalization companies, the European equity market, and the Pacific Basin
equity market.

2. What would happen to market efficiency if all investors attempted to follow a pas-
sive strategy?

The Role of Portfolio Management in an Efficient Market
If the market is efficient, why not throw darts at The Wall Street Journal instead of trying to
choose a stock portfolio rationally? It™s tempting to draw this sort of conclusion from the no-
tion that security prices are fairly set, but it™s a far too simple one. There is a role for rational
portfolio management, even in perfectly efficient markets.
A basic principle in portfolio selection is diversification. Even if all stocks are priced fairly,
each still poses firm-specific risk that can be eliminated through diversification. Therefore, ra-
tional security selection, even in an efficient market, calls for the selection of a carefully di-
versified portfolio. Moreover, that portfolio should provide the systematic risk level the
investor wants. Even in an efficient market, investors must choose the risk-return profiles they
deem appropriate.
Rational investment policy also requires that investors take tax considerations into account


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