Unforeseen Circumstances

"The Clairvoyant Society of London will not meet Tuesday due to unforeseen circumstances."
Burton Malkiel

This witticism uncovered by Burton Malkiel introduces Chapter 11 of his enduring classic A Random Walk Down Wall Street. This section of Malkiel's book rallies support for Eugene Fama's Efficient Market Hypothesis.

The Efficient Market Hypothesis simply states that market prices accurately reflect all available information at all times and that only unforeseen news or circumstances will provide reasons for future price changes. So, unless you can see the future, it is impossible to consistently beat the market averages. As French mathematician Louis Bachelier stated back in 1900, the expected return of speculation is zero, relative to the average.

A study by finance professor Richard Roll indicated that new information is reflected in market prices within just five to sixty minutes. Within that short span of time, there are hundreds, if not thousands of traders all competing to profit from the same information. If you are in charge of one billion dollars a 0.1% annual gain is worth one million dollars per year.

Consequently, managers of those funds are applying considerable resources to squeeze out every little gain from new information. For this simple reason alone, there is an absence of opportunities for one trader to consistently profit from all other traders who have access to the same information at the same time! Simply put, all of us as a group know more than any one of us, making it impossible for one person to consistently possess more knowledge than all the other traders combined. As a result, the price of a stock agreed upon by a buyer and a seller is the best estimate, good or bad, of the investment value of that stock. This simple logic makes it virtually impossible to capture returns in excess of market returns without taking greater than market levels of risk.

In Robert C. Higgins book, Analysis for Financial Management, he paints a vivid picture of how information is devoured by market participants: "Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are--plausibly enough--the piranha. The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence."

Eugene Fama is a finance professor at the University of Chicago's renowned School of Economics. His groundbreaking research led him to develop a comprehensive theory that explains why stock market prices fluctuate randomly. His paper Market Efficiency, Long-Term Returns, and Behavioral Finance is the #1 downloaded academic paper on the web and explains the most recent challenges to this hypothesis. To watch a video of Professor Fama explain his Efficient Market Hypothesis, click on the box below.