The previous plates built a market in which risk is the only thing rewarded, and beta the measure of how much of it an asset carries. This plate draws the conclusion that lies coiled inside that market, and it is the boldest, and most disquieting, in the volume so far. If the price of an asset already reflects every priced risk and every knowable fact — if all that is public has been weighed and built into the number — then the price is, given what can be known, already right; and no amount of study, however diligent, can reliably find it wrong. The hunt for bargains is the hunt for prices the market has mistaken, and in a market that makes no mistakes there are no bargains to find. From this follows the claim that has divided finance for sixty years: that the apparent triumphs of the great stock-picker are not the fruit of skill at all, but either disguised payment for bearing risk or the plain operation of luck — and that the humble fund which studies nothing and merely holds the whole market will, in the end, outlast most of those who study. This plate will set out the hypothesis and the competition that drives it; will lay out its three strengths and trace its hard consequence for the question of skill and luck; will weigh the substantial evidence in its favour; and will give its due to the great and unresolved quarrel over whether the market is, in truth, the cool rational engine the hypothesis supposes — or something a good deal more feverish.
State the hypothesis plainly. A market is efficient, in Fama's sense, when its prices fully reflect all available information. The mechanism of this reflecting is simply the trading of those who possess the information: let a fact emerge that bears on an asset's worth — a discovery, a disappointment, a turn in the wider world — and those who learn it will buy or sell upon it, moving the price, until the price has moved far enough to embody the fact and the chance to profit from it is gone. Because this happens fast, and because the watchers are many, the price at any moment already contains essentially everything that is known. And a price that contains everything known cannot be improved upon by anyone working from what is known: the diligent analyst, poring over public accounts, is working with information the price already reflects, and can no more find a reliable edge in it than a man can win a race that everyone has already finished. The efficient market does not say prices are always correct in hindsight — the future will surprise everyone — but that they are correct in foresight, given what can presently be known. Against the knowable, the price is unbeatable, because the price is the knowable, summed.
The engine of this efficiency is worth dwelling on, for it is a beautiful and slightly paradoxical thing. What makes the price reflect all information is precisely the effort of a multitude trying to beat it. Each analyst, each trader, each fund hopes to find a price the market has got wrong and to profit by the correction; and in the very act of searching, finding, and trading upon such errors, they erase them. Suppose an asset were underpriced, a genuine bargain. The first to notice would buy, and the buying would lift the price; others would notice and buy too; and the price would rise until the bargain was gone and the next searcher found nothing. The mispricing exists only in the instant before it is found, and the searching that finds it is the same searching that destroys it. So the market is made efficient not despite the crowd of profit-seekers but because of them: their collective hunt for mispricing is what leaves the price, in the end, with almost none. It is a competition that consumes its own prize — and the better and more numerous the competitors, the more completely the prize is consumed, until what remains for the marginal searcher is scarcely worth the search.
The bargain exists only in the instant before it is found; and the searching that finds it is the very searching that destroys it.
The hypothesis comes in three strengths, according to how much information the price is said to reflect. In its weak form, the price reflects all that can be read from its own past — every prior price and movement — so that the chartist who divines the future from the shapes of the past is chasing a ghost, for the price wanders at random and yesterday's pattern tells nothing of tomorrow's. In its semi-strong form, the price reflects all public information — the accounts, the announcements, the news — so that the analyst of public fact, however able, cannot reliably beat a price that has already digested the same facts. In its strong form, the price reflects all information whatever, including that held privately by insiders — a claim the evidence does not support, for those who trade on genuine secrets do seem to profit, which is precisely why the law forbids them. The weak and the semi-strong forms carry the real weight of the hypothesis, and command real, if contested, support; the strong form stands mainly as the limiting ideal against which the others are measured. The market digests the past surely, the public present nearly so, and the genuine secret not at all.
Here is the consequence that matters for this volume, and it falls hard upon the figure of the brilliant investor. If the market is efficient, then a record of beating it can mean only one of two things, and neither is skill in the sense the world supposes. It may mean that the beater was, knowingly or not, bearing more risk — more of the systematic kind the previous plate priced, or more of the subtler factor-risks beta missed — and earning the premium that risk commands; adjust his return for the risk he bore, and the apparent excess melts away. Or it may mean luck. Set ten thousand investors to picking, and chance alone will hand some of them long strings of triumph, as ten thousand coin-flippers will yield a few who flip ten heads running; these fortunate few will be feted as sages, will write their memoirs and found their schools, and will be indistinguishable, by their returns alone, from the genuinely skilled — if any genuinely skilled there be. The efficient market thus levels a grave charge: that the celebrated skill of the market-beater is, in the main, either risk wearing the mask of skill or luck wearing the same mask, and that his great fortune is less the wage of judgment than the prize of a draw — the very charge the diversification plate laid against the bold concentrated gambler, now extended to the whole apparatus of active investing.
The evidence for all this is, it must be said, substantial. When the records of professional fund managers are tallied honestly and their fees subtracted, the great majority are found to lag the simple market average they were paid to beat; and of the minority who beat it in one stretch, few do so in the next, their triumph fading into the run of chance as a hot hand cools. The plainest monument to the hypothesis is the index fund — the vehicle that buys the whole market and forecasts nothing, charges almost nothing because it employs no seers, and has, decade upon decade, quietly outperformed most of the expensive talent arrayed against it. That a strategy of deliberate thoughtlessness should beat most of the thought in the market is the efficient market's strongest argument, made not in theory but in the long arithmetic of returns. It is not a complete victory — stubborn anomalies remain, the factor-premia among them, and pockets where patient or specialised players do seem to earn their keep — but the central finding is robust and humbling: against the market, most cleverness loses, and the cleverest thing most investors can do is to stop trying to be clever.
The fund that studies nothing and forecasts nothing has, decade upon decade, quietly outlasted most of those paid to study and forecast.
And yet the hypothesis is among the most fiercely contested in all of economics, and the contest bears directly on the volume's question. For the same prices the efficient-market school reads as the cool and rational digestion of all that is known, a rival school reads as the record of something far less sober. Prices, the behavioral critics observe, swing far more violently than any change in the underlying facts can justify — soaring into bubbles and collapsing into panics, gripped by fashion and fear and the contagious certainty of crowds — so that the market looks less like a calm calculating machine than like a vast and excitable assembly, often not coolly right but feverishly wrong. If that is so, then prices are sometimes genuinely mistaken, bargains sometimes genuinely exist, and a cool head that keeps its judgment while the crowd loses theirs may, after all, reliably beat the market — and earn, by doing so, the honest wage of a real and rare skill. The dispute is not a minor one, nor close to settled: it is emblematic that the founders of the two schools, the prophet of efficiency and the prophet of exuberance, were awarded a single Nobel prize between them in the same year, as though the committee could not choose and the discipline could not decide. Beneath the quarrel lies a genuine difficulty of proof, for any test of whether the market is beating its proper price is also a test of what the proper price should be, and the two can never be wholly separated; and a genuine paradox besides, that if prices were perfectly efficient no one would be paid to gather the information that makes them so, and the gathering would cease — so that the market must be left a little inefficient, always, to reward the labour that keeps it nearly efficient.
The volume cannot settle what the discipline has not, but it can mark the stakes, which are exactly its own. If the market is efficient, then the only earned return to investing is the premium for bearing risk that the earlier plates described, and all the rest — every celebrated outperformance, every fortune raised on a reputation for genius — is luck wearing the mask of skill, indistinguishable by its returns from the gambler's draw. If the market is not efficient, then some part of investment return is the genuine wage of a rare judgment, earned by those who keep their heads while the crowd loses its own. The truth, as far as the evidence reaches, seems to lie nearer the first than the second — the market is hard to beat, and most who try fail — but not entirely at the first, for the bubbles are real and a little genuine skill seems to survive the test. Either way, the hypothesis has shifted the burden decisively: anyone who would call a great market fortune the simple reward of skill must now prove that it was not, instead, the reward of risk or the gift of luck — and must reckon with how nearly impossible that proof is to supply from the returns alone. How much of any fortune is skill and how much is luck, and why we so reliably mistake the second for the first, is the question the volume's closing plates exist to face. But first it must ask whether the price of risk itself — the very premium the efficient market takes as the just and only reward — is rightly sized at all; for there is a puzzle in its magnitude that no sober accounting has been able to lay to rest. As the table says of every price, first to last: the argument remains open.