Two economists are walking down the street. One spots a $100 bill on the ground and moves to pick it up. His colleague tells him to not waste his time because if that were a real $100 bill, someone would have already picked it up.
The Efficient Market Hypothesis (EMH) has long been a foundational concept in financial economics. It suggests that financial markets are “informationally efficient,” meaning that asset prices fully reflect all available information. As a result, consistently outperforming the market through expert stock selection or market timing becomes nearly impossible.
While I believe that EMH holds true in the long term, I’ve recently realized that it’s application in the short term is much more nuanced and depends on your individual circumstances.
Take, for example, the performance of actively managed mutual funds versus passive index funds. Numerous studies have shown that over extended periods—say, 10 to 20 years—most actively managed funds fail to outperform their benchmark indices after accounting for fees and expenses. This pattern underscores the idea that in the long run, markets efficiently incorporate information, making it exceedingly difficult for investors to achieve superior returns consistently.
Another example: following the Space Shuttle Challenger disaster in 1986. When the Challenger tragically exploded 73 seconds after liftoff, the exact cause was not immediately known to the public. However, within hours, the stock market had already singled out Morton Thiokol, the manufacturer of the shuttle’s O-rings, which were later identified as the failure point.
Despite the absence of an official investigation report, Morton Thiokol’s stock price plummeted while other contractors involved with the shuttle remained relatively unaffected. Investors collectively analyzed limited information—such as launch conditions and previous O-ring concerns—and quickly deduced the likely source of the problem.
This rapid adjustment in the company’s stock price illustrates how efficiently markets can assimilate and reflect information, even in complex and uncertain situations. Over the long term, the market had correctly identified and priced in the ramifications of the disaster for Morton Thiokol.
When we shift our focus to the short term, the picture becomes less clear-cut. The extent to which EMH applies in the short term hinges on two key factors:
First, what is the short term?
The definition of “short-term” is subjective. For a day trader, it might mean seconds or minutes; for a long-term investor, it could be months or even a few years. The shorter the time frame, the more susceptible the market is to inefficiencies caused by factors like emotional reactions, news events, or temporary supply and demand imbalances.
Speed matters and so do words.
Your individual ability to process information and act on it swiftly plays a crucial role. If you have the tools, knowledge, and agility to respond to market anomalies faster than others, you might exploit short-term inefficiencies. High-frequency traders, for instance, leverage advanced algorithms and technology to capitalize on minute price discrepancies that exist only for fractions of a second.
What does this mean for you? First, it’s important not to chase after ideas or investments that are already saturated and efficiently priced. Doing so is often irrational and unlikely to yield favorable results. Instead, focus on areas where you have a genuine edge or insight that the market hasn’t fully appreciated.
Moreover, take ownership of defining what the “short-term” means for you. Assess your personal pace of iteration—how quickly you can learn, adapt, and execute strategies. By understanding your unique capabilities and limitations, you can make more informed decisions that align with your goals and risk tolerance.
Sometimes, there really is a $100 bill lying around. While markets are generally efficient, they are not perfectly so. Opportunities do arise and there are a lot of wonderful things out there that we’ve yet to discover.