Efficient Market Hypothesis, Buffett's Views, and Fund Implications

This essay critically evaluates the contrasting views of Eugene Fama and Warren Buffett on market efficiency and its implications for an actively managed equity fund. It begins by introducing the concepts of market efficiency and behavioral finance, setting the stage for a discussion of Fama's efficient market hypothesis (EMH) and Buffett's counter-arguments. The essay explores the three forms of EMH (weak, semi-strong, and strong) and analyzes supporting and opposing research, using real-world examples to illustrate the debate. It then delves into Buffett's investment philosophy, particularly his focus on value investing and competitive advantages, and how his strategies challenge the EMH. The essay synthesizes academic literature and practical examples to assess the validity of both perspectives. The conclusion offers insights on market efficiency and provides recommendations for the fund's future direction, considering the balance between active and passive management, risk management, and the potential for outperformance. The essay emphasizes the importance of understanding market dynamics and making informed investment decisions.

Financial Markets and Institutes
2019

Introduction
Efficient Market Hypothesis or EHM can be thought of as a financial economic theory which
analyses the prices of the stocks available in the market and thereafter provides the user with
substantial knowledge about the same stock. It is also seen from this theory that the market
cannot be dominated because the stocks can change all over and this will change the collected
data and change all the plans. This is because the market depends on the stocks available on
it. It is also to be known that the assumption shares always trade on their base price which
can be positive. The efficient market hypothesis is a market scenario where it is not easy to
derive huge profits. It is also known as Random Walk Theory. The investors and financial
managers derive huge benefits from the efficient market hypothesis as it focuses on the
alterations taking place in the security markets and the reasons behind the occurrence of the
same (Delcey, 2015). The first person to ever use the term “efficient market” was E.F Fama
who believed that the intrinsic values can be clearly seen in the presence of a competitive
market.
Discussion of Fama’s views
E.F Fama classifies efficient market hypothesis into three categories that are listed below-
• Weak Form Efficiency
Weak form efficiency signifies that the current prices prevailing in the market fully project
the information carried by the previous prices only. This indicates that it is impossible to
detect such securities that are mispriced and therefore, the chances for overruling the market
are almost negligible (Decley, 2015). In this form of market efficiency, it is impossible for
one to make full use of available information in detecting mispriced securities and beat the
market.
• The semi-strong form of Efficiency
Semi-strong form efficiency signifies that the current prices prevailing in the market reflect
all such possible information that is publicly available. The main objective behind this form
of efficiency is to disallow the others to take undue advantage of such information that
someone else is aware of. This form of efficiency has various data from the financial
2

statements of the company like annual reports, dividends, merger plans, etc apart from just
previous prices (Hirshleifer, Hsu & Li, 2013).
• Strong form efficiency
Strong form efficiency signifies that the current prices reflect all the information may it be
public or private. Strong form efficiency signifies a market where predictions are made fairly
and the prices of securities reflect detailed information. It also signifies that the management
of an organization is unable to derive benefits from the insider information even if the same is
received in advance (Decley, 2015).
EMH depicts all such necessary information concerning the fundamental that is reflected
through security prices. EMH enables the investors in deriving huge benefits from employing
passive strategies and deploying the traditional ones. The hypothesis allows the assets that are
overpriced to be priced as per the risk is borne by the same (Bailey, Kumar & Ng, 2011). The
efficient market hypothesis is updated from time to time so that the actual prices prevailing in
the market are reflected. EMH depicts financing costs, agency costs, transaction costs, cost
information, etc. EMH allows the investors to understand the situations prevailing in the
market and use them accordingly so as to derive benefits. EMH is also useful for arbitrageurs
that make use of comparative advantage theory to earn profits (Bernard, 2011). The
arbitrageurs benefit from EMH because the hypothesis offers specialized knowledge, fewer
management fees and financial set up which allows them to consider such an option that has a
longer verification period. This allows the liquid markets to gain efficiency and depict a
positive picture of the same (Porter & Norton, 2014).
Investors nowadays can make use of an active management strategy, passive management
strategy or a combination of multiple approaches. A passive management strategy is
commonly known as indexing (Power, 2017). Indexed assets are invested on the basis of
specific rules that employ such an index that has multiple securities derived from giving due
consideration to the conventional performance and various risk features (Kaniel, Liu, Saar &
Titman, 2012). It is no doubt that the efficient market hypothesis always depicts that the
market price of security signifies valuable information. EMH has received a lot of critics ever
since the same got recognized.EMH allows the investors to identify the overpriced securities
which are criticized by various financial analysts and other portfolio managers (Delcey,
2015). Prices of such securities that have different participants must be adjusted as per the
new information by fair means. The theory states that an investor cannot overrule the market
3

but there are various analysts such as George Soros, Warren Buffet, Peter Lynch, etc who
have succeeded in beating the market and proved this belief wrong. The hypothesis theory
has mostly received a lot of criticism due to myths and inappropriate interpretations revolving
around the same. The price of securities in a market tends to fluctuate from time to time due
to the constant flow of new information. The investor is more likely to gain if the newly
released information turns out to be in favor of his investments. The efficient market
hypothesis states that the investors should not aspire to overrule the market but it is also true
that investors might beat the market out of luck or due to the efficiency of the same (Da, Guo
& Jagannathan, 2012). Take, for instance, an investor who invested in a security that has a 60
percent chance to outdo the market. The probability of beating the market for such an
investor in the upcoming ten years is (0.6)10. It must also be noted that there shall be at least
one investor who might beat the market in the upcoming ten years due to the fact that there
will be a rise in a number of investors contributing to this scenario from time to time. There is
a 63% probability of having a winner with a ten-year record in the presence of 1000 investors
and 99.99% probability of having a winner with a ten-year record in the presence of 10000
investors.
Discussion of Buffett’s views
As an investor, Buffett worked towards gaining a competitive advantage over his rivalries in
the industry. It is a known fact that the organizations that have a competitive advantage are
most likely to have higher returns on its capital as compared to their competitors. Having a
competitive advantage is appreciated in the real economy yet the presence of the same is still
unrecognized amongst professional investors. The story is no different in the financial
markets as well. Buffett’s case was declared accidental by the supporters of the efficient
market hypothesis. In order to have a better understanding of the EMH one has to analyze all
the factors irrespective of the fact whether they belong to financial theory or not. One must
not always need to consider the terms of financial theory so as to understand the functioning
of the real world (Ashanti, 2018). Out of three factors that accounted in the abnormal returns
for Buffett, two were financial and one was non-financial. The non-financial factor was one
where the returns were increased by almost three percentage points as compared to the
standards prevailing in the market. This is a kind of value investing approach. Buffett was
able to gain a competitive advantage over other investors in a specific market domain in a
very short time. It takes years for someone to gain a competitive advantage over others in any
industry (Bloomberg, 2018). Therefore, it is difficult for anyone to address how Buffett
4

gained a competitive advantage over other investors in such a short span of time. Warren
Buffett’s case can be justified by all these three factors but still, there were a lot of critics
coming from journalists and financial scientists claiming that Buffett’s success was just
random and pure luck. Going through all the three factors one must believe appreciate
Buffett’s success and not question the same.
The truthfulness of two aspects decides the success of fundamental analysis. The first aspect
is where the market has to ignore such significant factors that can be noticed only by means
of carefully analyzing information that is publicly available about an organization’s value
(Ashanti, 2018). The second aspect is the most important one as there is a need for the
industry to realize an organizations’ true value. This is highly due to the fact that if an
industry never identifies an organization’s true value, then in order to make a profit from
dividends and share buybacks one has to hold the stock for a longer period (Konak & Seker,
2014). One can cash out and receive profits in a year or two if the market realizes the true
value of a deserving organization which is very essential for ones who are managing funds
and are required to reflect yearly gains. Buffett believes that ones who read their Graham and
Dodd shall always prosper (Bloomberg, 2018). All the nine funds that Buffett has invested in
are completely different from one another. These funds have only two similar qualities that
are a value strategy and a personal connection to Buffett. These funds have outperformed the
market averages over a due course of time.
An apt example of Buffet investment strategy that is used by an investor lies in the fact that
an investor should vouch for the riskier companies as compared to the ones that provides
unique offerings. In the current the same is prevalent because the clients or the investors
purchase products from the companies and have a tendency to move to other competitors if
the same kind of product is being offered. Hence, in the present scenario, the investors are
always vouching for the company that has the capacity to provide high quality and desirable
products. This is the main point of view of Buffet that the investors are following in the
current scenario.
From this case study, it is realized that the stock market is highly efficient and it ultimately
depends on an investor that how he analyses all the aspects and scenarios reflected from the
strategies of the management of an organization so as to make an appropriate investment
related decision. In all probability, it depends upon the investor to take a call on the
investment that is needed. There are various factors present in the market and it really matters
5

to the investor to decide how the factors should be ascertained. Investors must opt for a
passive strategy so as to gain competitive advantage otherwise the returns are most likely to
reduce due to the presence of various costs that are incurred. This doesn’t mean that the
portfolio management has got no significance. The concept of diversification and allocation
of assets can always enhance returns. It is one of the prime methods that enable the investors
to keep the risk at bay (Titan, 2015). This means that investors must always aim at procuring
an optimum return. This is why there are a lot of books published every year by investment
professionals focussing on how to beat the market blues and make millions of dollars. The
efficiency of a market is highly determined with the presence of a neck to neck competition
that ultimately allows the prices to fluctuate from time to time as a result of floatation of
newer information every day, hour and minute (Mallaby, 2010). This means that the investors
earn returns on their investments as a result of risks undertaken by them along with the
compensation they make for the time value of money. It can be said that the process of active
security management is losing its essence due to the significance it now gives to risk as well
as a transaction cost.
6

Conclusion
The efficient market hypothesis states that the market prices depict all the new information
which is not completely true as the users can check the fluctuations in prices because of the
same changes every minute, day and hour. The efficiency of a market can be determined
from the continuous adjustment of prices. The value of the securities is influenced by new
information and this ultimately leads to constant fluctuations of prices. Therefore, it is right to
say that the fluctuations in prices reflect market efficiency as there is new information
coming every minute, hour and day. The scope of market efficiency arises when there are
such investors in the market who are less informed but skilled at the same time as most of the
investors chose not to track their investments. With the expansion of the market, it is essential
that high intensity of market data needs to be processed and thereby it is essential to have a
high increment in the trade execution and other opportunities that lie for information
asymmetry. But, the proponent of the EMH puts n argument that it is valid under the
conditions where the fluid is present in the market and opportunities exists for trade.
7

References
Ashanti, K. (2018). How to Invest Like Warren Buffett – 5 Key Principles. Retrieved from
https://www.moneycrashers.com/invest-like-warren-buffett/
Bailey, W., Kumar, A. and Ng, D. (2011). Behavioral Biases of Mutual Fund Investors.
Journal of Financial Economics, 102(1), 1–27. Retrieved from
https://courses.cit.cornell.edu/wbb1/papers/Bailey_Kumar_Ng_FOR_JFE_16July201
0.pdf
Bernard,G. (2011). Efficient Market Hypothesis: What are we talking about? Real-world
economics review 56, 19-30. Retrieved from
http://citeseerx.ist.psu.edu/viewdoc/download?
doi=10.1.1.410.6013&rep=rep1&type=pdf
Bloomberg. (2018). Rational markets theory keeps running into irrational humans. Retrieved
from https://economictimes.indiatimes.com/markets/stocks/news/rational-markets-
theory-keeps-running-into-irrational-humans/articleshow/63591787.cms
Da, Z, Guo, R.J and Jagannathan, R. (2012). CAPM for estimating the cost of equity capital:
Interpreting the empirical evidence. Journal of Financial Economics 103, pp. 204–
220
Delcey, T. (2015). Efficient Market Hypothesis, Eugene Fama and Paul Samuelson: A
reevaluation. 2018. Retrieved from
https://hal.archives-ouvertes.fr/hal-01618347/file/Delcey%2C%20WP1%2C
%20Fama-Samuelson.pdf
Hirshleifer, D., Hsu, P.H. and Li, D. (2013). Innovative efficiency and stock returns. Journal
of Financial Economics, 107, 632-654. Retrieved from
http://www.sciencedirect.com/science/article/pii/S0304405X12001961
Kaniel, R., Liu, S., Saar, G and Titman, S. (2012). Individual investor trading and return
patterns around earnings announcements. Journal of Finance, 67(2), 639–680. DOI:
https://doi.org/10.1111/j.1540-6261.2012.01727.x
Konak, F & Seker, Y. (2014). The Efficiency of Developed Markets: Empirical Evidence
from FTSE 100. Journal of Advanced Management Science, 2(1). Retrieved from
http://www.joams.com/uploadfile/2013/1225/20131225041436878.pdf
8

Mallaby S. (2010). More Money than God. Hedge Funds and the Making of a New Elite. The
Penguin Press. New York
Porter, G. and Norton, C. (2014). Financial Accounting: The Impact on Decision Maker.
Texas: Cengage Learning
9