The Efficient Market Hypothesis is a Philosophical Razor

I’ve read some inane discussions about the validity of the efficient market hypothesis (EMH). I’ve even participated in some. Proponents warn that cocky retail traders are naive, and detractors point to historical examples of inefficiencies.

I claim this is a category mistake by both parties. The EMH is more like a philosophical razor: you should accept it for a given asset, unless you have some information to the contrary. We might as well call it the efficient market null hypothesis.

The efficiency of the market depends on the observer, and the information they have.

The EMH allows you to hedge

Suppose you think $SUNY, a solar energy company, is undervalued; their new patents will cause their stock price to rise. You may be a smart guy, but that price reflects the beliefs of many smart people. Going off of prior alone, it’s unlikely you know something they don’t; it should take a preponderance of evidence to convince yourself that you know something others haven’t adequately considered!

But you’ve been throrough in your research, and so you buy shares of $SUNY. But your thesis is specific to that company, so you hedge out the industry-related risk by short selling an equal value of shares of comparable companies in the renewable energy sector, like wind or hydroelectric power companies.

In so doing, you reject the EMH for $SUNY, but assume it when you hedge. Without special information, you put your trust in the active investment managers of the world to appropriately price your hedging instruments - otherwise, you wouldn’t be hedging at all.

This isn’t an original take

Grossman and Stiglitz (1980) showed that the theory of efficient markets entails a paradox. If the market is efficient, there’s no point in doing fundamental analysis, which makes the market inefficient, which incentivizes fundamental research again, which makes the market efficient again, ad infinitum.

In Efficiently Inefficient, Lasse Heje Pedersen resolves this like so: market prices “reflect enough information to make it difficult to make money, but not so efficient that no one wants to collect information and trade on it.”

The cost of acquiring and digesting information varies. For a dork like me, it is prohibitively expensive to collect information and trade on it, but not so much for sophisticated institutional traders. The latter should reject the EMH much more than me, and indeed they do!