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Testing EMH: The Joint Hypothesis Problem

Hypotheses cannot be proven. They can only be disproved. As Taleb reminds us, even with hundreds of thousands of white swan sightings and no black swan sightings, it was never possible to prove the statement “all swans are white.” Yet one single sighting of a black swan could (and did) immediately disprove the statement.

In finance, people often seek to disprove the efficient market hypothesis (and thereby give hope to active fund managers, active fund investors, stock pickers, market timers, and stock newsletter publishers that their efforts aren’t doomed to failure). The trick is that EMH is an incomplete hypothesis, and it cannot be disproved.

Testing EMH

We can say “markets are efficient” and “an efficient market would look like X.” But if we test, and find that markets don’t look like X, we don’t know whether:

  • Markets are not efficient, or
  • Our description of what an efficient market looks like is inaccurate/incomplete.

This is what’s known as the joint hypothesis problem. When we attempt to test EMH, we’re automatically testing two hypotheses:

  1. “Market’s are efficient” <— the efficient markets hypothesis, and
  2. “Efficient markets look like X.” <—the secondary hypothesis.

If the joint hypotheses are proven false, it’s impossible to know which one was proven false.

For example, we might describe an efficient market as one in which asset classes have expected returns proportional to their risk (as measured by volatility of returns). And if we found two asset classes with equal volatility where one reliably outperformed the other, we might be tempted to say that markets are not efficient.

But that’s not necessarily the case. Perhaps the market is smarter than our description of it, and there are other factors at work. For example, there may be forms of risk other than volatility (illiquidity for instance) that would cause an efficient market to allow one asset class to have higher expected returns than the other.

The Takeaway for Investors

So what’s the point of all this? The point is that you should be extremely leery anytime you see somebody claiming that:

  1. “Markets are not efficient, and I have proof!” or
  2. “I can help you increase your return without increasing risk.” (which, by the way, is just the I’m-about-to-sell-you-something version of claim #1).

Of course, for precisely the same reason EMH can’t be proven false, it can’t be proven true either. EMH’s value lies, in my opinion, not in our ability to prove or disprove it but rather in its usefulness as a lens through which we can examine market phenomena and perhaps come to a better understanding of why the market does what it does.

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  1. You make some good points, Mike. I hadn’t considered it that way before, but that does throw a wrench in many active investors’ claims that EMH is completely false.

    Have you ever discussed the various forms of EMH? Weak, semi-strong, and strong?

  2. Hi Paul.

    Perfect example! (I talked about the 3 common EMH forms on Thursday.) The 3 common forms of EMH are, essentially, the most common joint hypotheses (in that they add something to the hypothesis “markets are efficient” in order to make it testable), though there could be numerous others.

  3. Ah, sorry I missed that! That’s a good summary of the three forms. You also reflected my personal beliefs in that article as well. Weak form is quite accurate, semi-strong a little less, and I don’t think there’s any truth to strong form.

    Anyway, I liked these two articles. I’m not sure how many people will enjoy them who aren’t into the technical aspects of investing though. 🙂

  4. Anyway, I liked these two articles.

    Thanks! 🙂

    I’m not sure how many people will enjoy them who aren’t into the technical aspects of investing though.

    Yeah…I was expecting that, hehe.

    I generally try to avoid getting too deep into the technical stuff. But this time I decided to bite the bullet and write about it anyway–while EMH is fairly “out there” for the average investor, a ground-level understanding of the idea seems quite important to me.

  5. Mike,

    Hey, I liked the post on the 3 common forms of EMH too!

    The thing I find most valuable is that there hasn’t been any sufficient analysis of the value of technical analysis or fundamental analysis to send EMH to the scrap heap.

    I am a bit surprised that insider trading hasn’t banished strong EMH though. It seems like knowing disastrous or wonderful sales numbers before the rest of the market would be a sure way to beat the market. Isn’t that why it is illegal?


  6. “I am a bit surprised that insider trading hasn’t banished strong EMH though. It seems like knowing disastrous or wonderful sales numbers before the rest of the market would be a sure way to beat the market. Isn’t that why it is illegal?”

    Exactly, Rick! There’s an obvious benefit to insider information, which makes strong form EMH completely absurd in my opinion.

  7. Yep, even Eugene Fama himself has said that insiders tend to outperform the rest of the market.

    It seems to me that strong-form EMH is really just a sort of straw-man argument. It’s just the logical extreme of EMH, not a particularly accurate description of the market.

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