The Three Forms of the Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH), systematized by Eugene Fama in the 1960s, asserts that market prices instantly reflect all available information. The hypothesis comes in three forms. The weak form holds that past price data is already incorporated, negating the usefulness of technical analysis. The semi-strong form states that all public information (earnings, news, economic indicators) is already reflected, making excess returns through fundamental analysis difficult. The strong form is the most extreme, claiming that even insider information is priced in.
Empirical research generally supports the weak and semi-strong forms, but evidence against the strong form is abundant. Numerous cases of excess returns from insider trading have been documented, indicating that perfect information efficiency does not hold in reality. However, what matters most for the majority of investors is the semi-strong implication: it is extremely difficult to consistently beat the market using only publicly available information.
Why EMH Supports Index Investing
The logical conclusion of EMH is straightforward. If markets are broadly efficient, consistently outperforming the market average through active management is difficult, making low-cost index funds that invest in the entire market the rational choice. Real-world data backs this up. According to the SPIVA report, approximately 90% of U.S. large-cap active funds underperformed the S&P 500 over the past 15 years. A similar trend exists in Japan, where active funds that consistently beat TOPIX over the long term are a minority.
The biggest factor working against active funds is cost. introductory books on index investing explain in detail how the fee differential (active: 1-2% per year, index: 0.1-0.2% per year) compounds over time, creating a structural disadvantage where active funds lag the market average by the amount of their costs.
Criticisms of EMH and Market Inefficiencies
EMH is not a universal theory, and it faces many criticisms. Behavioral finance researchers have demonstrated that irrational investor behavior (overreaction, herd mentality, loss aversion) creates systematic distortions in markets. Anomalies such as the value effect (cheap stocks outperforming expensive ones over time), the momentum effect (rising stocks continuing to rise), and the small-cap effect (small stocks outperforming large ones) suggest that markets are not perfectly efficient.
However, these anomalies tend to diminish after discovery, and profiting from them after accounting for transaction costs is far from easy. books on behavioral finance and market efficiency provide an overview of the debate between EMH and behavioral finance, along with practical stances individual investors should adopt.
Rational Guidelines for Investors Based on EMH
The practical lesson individual investors should draw from the EMH debate is clear. There is no need to settle the academic argument over whether markets are perfectly efficient - the starting point is accepting the empirical fact that consistently beating the market is extremely difficult. A realistic approach is the "core-satellite strategy": allocate 80-90% of core assets to low-cost index funds, and use the remaining 10-20% to experiment with individual stocks or active funds.
Start by comparing the past five-year returns of your active funds against their benchmarks (TOPIX or S&P 500). If the returns after deducting management fees fall short of the benchmark, it is worth considering a switch to index funds. When making the switch, factor in the tax implications and begin by redirecting new contributions in your NISA account to index funds - that is the most rational first step.