Origins
The Efficient Market Hypothesis (EMH) emerged from the University of Chicago in the 1960s as economists sought to explain why stock prices appeared to follow a “random walk”—moving unpredictably from day to day. Eugene Fama formalized the doctrine in his 1965 dissertation and subsequent papers, arguing that in competitive markets with many informed participants, prices rapidly incorporate all available information.
The intellectual roots trace to earlier work by Louis Bachelier (1900) and Paul Samuelson (1965), who demonstrated mathematically that properly anticipated prices fluctuate randomly. The EMH provided a theoretical foundation for understanding why active stock-pickers consistently failed to outperform simple market averages: if prices already reflected all known information, there was no exploitable edge.
Structure & Function
Fama identified three forms of market efficiency, each defined by the type of information prices reflect. The “weak form” asserts that prices incorporate all past trading data, meaning technical analysis cannot generate excess returns. The “semi-strong form” holds that prices reflect all publicly available information, meaning fundamental analysis of financial statements provides no systematic advantage. The “strong form” claims prices reflect even private, insider information.
The doctrine’s core mechanism is arbitrage: when prices deviate from true value, informed traders rapidly buy underpriced assets and sell overpriced ones, driving prices back to equilibrium. This “invisible hand” of competitive trading ensures that mispricings are fleeting and hard to exploit after accounting for transaction costs.
Historical Significance
The EMH revolutionized both academic finance and practical investment management. It provided the intellectual foundation for index funds, which accept market returns rather than attempting to beat them. John Bogle’s founding of Vanguard in 1975 translated the doctrine into a mass-market product that now manages trillions of dollars.
However, the doctrine has faced sustained criticism. The behavioral finance movement, pioneered by Daniel Kahneman and Amos Tversky, documented systematic psychological biases that cause investors to deviate from rationality. Major market events—the 1987 crash, the dot-com bubble, the 2008 crisis—challenged the notion that prices reflect fundamental values. Robert Shiller’s research on “excess volatility” suggested markets are subject to massive bubbles and crashes inconsistent with efficiency. Today, most practitioners accept a nuanced view: markets may be “micro-efficient” (individual stocks hard to beat) while remaining “macro-inefficient” (subject to aggregate mispricings).
Key Developments
- 1900: Louis Bachelier’s dissertation applies probability theory to stock prices.
- 1965: Paul Samuelson publishes “Proof That Properly Anticipated Prices Fluctuate Randomly.”
- 1965: Eugene Fama publishes his dissertation on the behavior of stock prices.
- 1970: Fama publishes “Efficient Capital Markets,” defining weak, semi-strong, and strong forms of efficiency.
- 1973: Burton Malkiel publishes A Random Walk Down Wall Street, popularizing the doctrine for a general audience.
- 1974: Paul Samuelson challenges investment professionals to provide empirical evidence that they can beat the market.
- 1970s: Daniel Kahneman and Amos Tversky begin identifying systematic psychological biases that challenge investor rationality.
- 1980: Sanford Grossman and Joseph Stiglitz publish the “Grossman-Stiglitz Paradox,” noting that perfectly efficient markets would eliminate incentives to gather information.
- 1986: Fischer Black publishes “Noise,” arguing that noise trading allows for profitable opportunities while complicating efficiency.
- 1992: Fama and Kenneth French publish research suggesting size and value factors explain returns beyond simple market beta.
- 1997: Andrei Shleifer and Robert Vishny publish “The Limits of Arbitrage,” explaining why mispricings may persist.
- 2005: Robert Shiller and Jeeman Jung support “Samuelson’s Dictum”—markets may be micro-efficient but macro-inefficient.
- 2013: Eugene Fama and Robert Shiller share the Nobel Prize despite their conflicting views on efficiency.