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rom Bachelier to Fama: Who is the real founder of efficient market theory
The efficient market hypothesis (EMH), a core concept in financial economics, argues that all available information is already reflected in asset prices, making it impossible to consistently "beat the market" after risk adjustment. The theory's roots can be traced back to several pioneers, but the work of Eugene Fama was particularly influential. His review article published in 1970 provided an in-depth analysis of theoretical and empirical research, which brought EMH to the forefront of public attention. In this context, should Bachelier be considered the true founder of this theory?
The efficient market hypothesis states that market prices can only respond to new information, so professional investors cannot consistently beat the market.
The theoretical background of EMH is based on the fundamental theorem of asset pricing, which predicts that stock prices are equal to the discounted value of future prices and dividends. On this basis, the stock market appears to operate in a way that acknowledges how information affects prices. However, over time, especially after the 1980s, many studies began to raise objections to market efficiency, especially with respect to the predictability of stock returns.
In the 1950s and 1960s, research by Alfred Cowles showed that professional investors were generally unable to outperform the market. With the introduction of EMH, many researchers began to examine financial data from the past few years to explore the behavioral characteristics of the market. Bachelier's 1900 paper "The Theory of Speculation" is considered one of the cornerstones of this theory. In the paper, he mentioned that "past, present and even discounted future events are reflected in market prices."
Bachelier's work was not taken seriously until the late 1950s, when it was rediscovered and his influence on financial mathematics began to grow.
Fama, through his doctoral dissertation and subsequent research in the 1960s, strengthened the definition of superficial efficiency and showed that even public information can be used by market participants. His research covers three test specifications: "weak form", "semi-strong form" and "strong form" efficiency. These categories have provided a more systematic understanding, but have also sparked much criticism, particularly from behavioral economists.
Behavioral economists point out that flaws in financial markets often stem from human cognitive biases and behavioral errors, and these accumulated errors lead them to make irrational investment decisions.
Over the past few decades, studies by Dreman and Berry have shown that even low P/E stocks have higher returns than the market average, questioning the validity of the Capital Asset Pricing Model (CAPM). Subsequent research has gradually tended to focus on risk factor models, such as the Fama-French three-factor model, which aims to explain market anomalies.
Many prominent investors, especially figures like Warren Buffett, have openly challenged the EMH. Buffett emphasizes value investing in his investment strategy, which is an expression of confidence in short-term market fluctuations. He argues that blindly following the market can lead investors to suffer losses, and questions the effectiveness of the market, arguing that successful investors in the long run do not rely solely on luck.
In his 1984 speech, Buffett said: "Standard market theory cannot explain the existence of investors who make huge profits over the long term."
Current research continues to explore the connection between market efficiency and behavioral psychology, revealing how the behavioral biases of market participants affect asset price formation. Many scholars have begun to focus on the concept of "liquidity", believing that it is crucial to capturing market "inefficiency". However, testing this interpretation based solely on data often faces problems with common assumptions, bringing us to a key challenge: Are markets really efficient?
With the rise of artificial intelligence technology, many scholars have begun to rethink the applicability of EMH, believing that future market participants will become more efficient. This discussion about market efficiency is far from over, and perhaps we should think about: Is there a more flexible theory to understand the relationship between the complexity of financial markets and human behavior?
