Practical analysis for investment professionals
15 November 2013

The Fallibility of Efficient Markets Theory

It’s long past time for professional investors to set aside the efficient market hypothesis (EMH) as the basis of most asset management strategies, according to Paul Woolley, a senior fellow at the London School of Economic and Political Science. Noting that earlier, on the first day of the Sixth Annual European Investment Conference, keynote speaker Martin Wheatley had discussed ethics, trust, and governance, Woolley dismissed those issues as secondary to the primary problem — the intellectual framework in which finance is conducted. “I blame the academic theory of efficient markets for the successive crises we’ve had,” Woolley said.

The EMH, he said, assumes that competition results in asset prices that reflect fair value and self-stabilizing capital markets, allowing no room for excess returns for intermediaries. Further, it does not address what Woolley called the “three perversities of investing”: momentum, short-termism, and risk-return inversion. The way forward, according to Woolley, is an asset pricing model that recognizes that investors delegate to agents, and these intermediaries have different degrees of competence and different objectives. This leads to asset mispricing and “rent capture” by agents.

Continue reading on the European Investment Conference blog

About the Author(s)
David Larrabee, CFA

David Larrabee, CFA, was director of member and corporate products at CFA Institute and served as the subject matter expert in portfolio management and equity investments. Previously, he spent two decades in the asset management industry as a portfolio manager and analyst. He holds a BA in economics from Colgate University and an MBA in finance from Fordham University. Topical Expertise: Equity Investments · Portfolio Management

4 thoughts on “The Fallibility of Efficient Markets Theory”

  1. Subhank Modi says:

    See in India itself there are many stocks trading below their book value and many stocks with high PE,ofcourse they are quality names.But what im saying is the gap between mid/small cap valuation is huge in India so I think there is a lot of money to be made in high beta stocks in India.
    Standard Disclosure:Relatives hold stocks like Unitech,DLF,HDIL,IVRCL Infrastructure,Alok Textiles,RS Software,Aftek in India.

  2. Savio Cardozo says:

    If memory serves me right the EMH allows for deviations from its pure form in the short-term where information is not immediately widely disseminated such in the three perversities listed by Mr. Woolley or even information asymmetry in countries like India that Mr. Modi mentions above or in the extreme short-term (nanosecond) arbitrage using computers. Perhaps what Mr. Woolley is getting at is what the arbitrage folks have been actively trading on for some time – that is there are opportunities to be taken advantage of in the short-term, not that the EMH is flawed in itself.

  3. Peter Eickelberg says:

    I have to ask whether this statement is correct or complete: “The EMH…assumes that competition results in asset prices that reflect fair value and self-stabilizing capital markets, allowing no room for excess returns for intermediaries.”

    I have heard Dr. Fama speak on this issue, and he contends that people don’t understand what EMH is really saying. I have always taken it to mean that the market price reflects available information efficiently so that if you lack inside information, you are just guessing that the price should be different than it is. And even I might have it wrong here, because I’m rusty on the actual paper that laid out this concept.

    I think the responsible thing to do is to refer back to what has actually been published/clarified on EMH and make sure you are blaming the right thing. If the real problem is lazy thinking rather than the intellectual framework, that would make more sense to me.

  4. larrabeecfa says:


    Thank you for visiting our blog and for your comments. Though not a direct quote, I believe that the statement you reference is a fair characterization of Woolley’s remarks and his criticism of the EMH, as originally presented in Fama’s “The Behavior of Stock Market Prices” (1965). According to Woolley, the EMH does not account for the fact that investors often delegate to intermediaries with different incentives and levels of competence, which leads to mispricing and volatility. Fama thinks this variability in returns is perfectly rational, while Woolley and other behavioralists see it as irrational.

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