Strong Form of the Efficient-Market Hypothesis

Strong Form of the Efficient-Market Hypothesis

The strongest form of the efficient-market hypothesis is unlikely to hold. We know that stock splits, dividend increases, and merger announcements can have substantial effects on share prices. Consequently, insiders trading on such information can clearly profit before the announcement is made. While such trading is illegal, the fact that the market often at least partially anticipates the announcements suggests that it is possible to profit on the basis of privileged information.

We also know that corporate insiders typically do well when trading stocks of their own companies. Stocks purchased by insiders often outperform the stocks in a randomly selected group. Moreover, distributions by “knowledgeable” sellers have often preceded significant price declines. Thus, the strongest form of the efficient-market hypothesis is clearly refuted.

Of course it is possible for insiders acting on the basis of information about an important mineral strike to make profits at the expense of public investors not privy to that information. Such things have happened in the past with too much frequency. But situations like that involving Texas Gulf Sulphur, where insiders allegedly profited from news of mineral discoveries at the expense of the public, are now less likely to occur than in the past. Of course, those who know in advance about a future takeover bid at a large premium over current market prices can profit from that knowledge. But arbitrageurs such as Ivan Boesky who have been convicted of securities violations have, in fact, spent time in jail – albeit a jail that bore some resemblance to a country club. It is also possible for columnists writing in widely read financial publications to profit from advance information of a bullish story concerning a particular security. But when they are caught utilizing this information themselves or selling it to others, they get fired and go to jail, as R. Foster Winans of the Wall Street Journal discovered.

Problems are not stop signs, they are guidelines (Robert H. Schuller). Photo by Elena

In recent years, the Securities and Exchange Commission has taken an increasingly tough stand against anyone profiting from information not generally available to the public. The SEC has put the investment community on notice that corporate officials, arbitrageurs, and anyone else acting on material that is not public information do so at their own peril. More recently, the SEC has extended this warning to any investor acting on this information, even if he hears about it third-hand – such as through his broker. It is small wonder that many a company president who thinks he has told a visiting security analyst some relevant piece of information he has not made available to others will immediately issue a press release to rectify the situation.

Thus tightened rules on disclosure make time lags in the dissemination of new information much shorter than they may have been in previous years. Of course, the more quickly information is disseminated to the public at large, the more closely the market may be expected to conform to the random-walk model. While the evidence on insider trading indicates that the very strongest form of the theory is not valid, there is considerable evidence that the market comes reasonably close to strong-form efficiency.

Several studies have been performed on the records of professional investment managers. In general, they show that randomly selected portfolios or unmanaged indices do as well as or better than professionally managed portfolios. What is remarkable is how well the data continue to confirm the extraordinary efficiency of the market. Most managers of the equity portfolios of pension funds could have substantially improved their performance by casting their lot with the efficient-market theory and not trying to outguess the market. In sum, it is true that the strongest form of the efficient-market theory does not hold and that scattered pieces of evidence have been found that are inconsistent with the semi-strong and weak forms of the theory. The market does not meander as a perfect random walk. But the proof of the pudding for me – convincing me that markets are still highly efficient – is that professional investment managers are not able to outperform the broad market averages. No investor can afford to ignore this important fact of life.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.