EMH Ramifications

Ramifications of the Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis (EMH) asserts that the stock prices already reflect all available information. Anything known to investors cannot lead to above normal profits; however, if someone can dig up information that is not known to other investors, he might be able to make a fortune.

For example, take a manager of a large fund of $10 billion. If he could find a way to make above normal profits of just 1%, he would earn an extra $100 million for the fund. If he could find a way to make above normal profits of just .1% he would still earn an extra $10 million. Even above normal profits of .01% would earn an extra $1 million, so he would be willing to invest up to $1 million just to earn an extra .01%. Situations like these have led to billions of dollars of investing in computers, analysts, and anything that may give an investor an edge. Once an investor finds something, he probably has a limited time before the information can no longer be used effectively (because others will discover it and eventually it won't be unique).

On the other hand, it leaves an investor like myself in the dust. Unless I'm a savant, it's unlikely that I'll come up with anything that hasn't already been discovered and woven into the market. If I only have $50,000 to invest, it's unlikely that I'm willing to spend significant time and money to get the extra .01% return of $5.

This also means that technical analysis on the lay-investor level is pretty worthless. All of the charts that you can get at Yahoo Finance or Bloomberg really don't tell more than whether you've lost money on a stock or not--no conclusions with predictive power can be drawn from these. It means that fundamental analysis doesn't do much good either. If the information is already in the market then the information is already reflected in the stock price.

This knowledge comes in handy when one is faced with claims of 100% returns. It's also usful in determining whether to invest in a managed mutual fund or an indexed fund. Can managers really beat the S&P 500 consistently? Although it's possible, it's not very likely. There are always some funds that consistently beat indexed funds, but there are also many that don't. Indexed funds have much lower costs since they don't need managers and analysts researching and making decisions, so even if a managed fund does have a slightly higher return, it's likely that the fees will make up the difference. Also, if a manager can obtain above normal returns for a fund, he'll most likely charge a premium to use his talent to manage a fund?

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