The Efficient Market Hypothesis, Fact Or Fiction? Part 3

Part one of our series introduced the efficient market hypothesis. Part twoexplored evidence in the mutual fund and pension plan worlds that showed that while the EMH fails all the tests of efficiency, it passes the only test that really matters – are active investors likely to outperform appropriate benchmarks after the expenses of the effort? Today, we’ll look at how the markets become efficient.

Markets are made efficient by the participation of many active investors, each of them attempting to gain a sustainable competitive advantage in terms of information. It’s important to understand that the competition among all the highly skilled competitors makes it very difficult to gain any competitive advantage. The ability to rapidly incorporate new information is so great that the market quickly eliminates most excess profit opportunities.

Does the existence of an efficient market make it impossible to gain a competitive advantage and be able to outperform the markets? That’s not a likely proposition. However, it does mean that the competitive advantage is likely to be short lived. In other words, “an occasional free lunch is permitted, but free lunch plans are ruled out.” Let’s explain.

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