The efficient market hypothesis underlies much of modern portfolio theory (such as index investing). One particular nasty consequence is that this assumption makes a lot of investment theory mathematically tractable. The problem is that many people believe that a theory is credible once it is presented in the precise language of mathematics. Read about the difference between precision and accuracy here.

Popular physics joke: Assume that the horse is perfectly spherical and moves on a frictionless surface, then it’s motion can be written as …

There are three versions or forms of the efficient market hypothesis. These are known as the weak, semi-strong and strong version.

The weak version says that investors can not gain an advantage by knowing the past history of stock price movements. In other words, it says that technical analysis is futile. This may have some truth to it now as few technicians make a killing in the market. It was not always true. Dow theory did work at some point and a few technical methods such as the Dogs of the Dow still work. In other words, the weak market hypothesis says that technical analysis is not worth it.

The semi-strong version says that investors can not gain an advantage by knowing the past history of stock price movements and all available public information (news, annual reports, P/E, P/B, P/S, … ). This may also have some truth to it as many analysts are paid handsomely to pour over company news to immediately adjust prices if something happens. In other words the semi-strong hypothesis says that fundamental analysis is not worth it.

The strong version says that investors can not gain an advantage by knowing the past history of stock price movements and all public information and all private (inside) information. In other words, everybody knows everything at all times. This means that even insiders can not obtain consistent above average returns.

The logical conclusion of this is that since no one can gain an advantage through technical or fundamental analysis it does not pay for anyone give any consideration to what a stock should cost. Therefore we might as well all save the effort and buy index funds. Whoa! Hold your frictionless spherical horses right there!

Let’s reconsider this attitude taking it to its logical conclusion. If we’re walking along the edge of a cliff holding on to a rope, nobody gains an advantage since we all hold on to the same rope. Therefore we might as well all close our eyes and stop paying attention. Until …

The system theoretical effect of index funds is to leverage market information and make it more significant than it is. This produces a systemic weakness or a tail wagging the dog problem. In other words the index fund investment style that the efficient market hypothesis brought about might be the downfall of the efficient market hypothesis itself.

This merely repeats what is well known but often forgotten. There is no free lunch in the pursuit of higher returns. It’s called risk-free for a reason.

Originally posted 2008-02-19 07:13:22.