Stock Market Efficiency

A long and interesting story lies behind the ever-popular efficient stock market theory, a story every stock investor should know. Knowing the EMT story will enable you to evaluate advice based on it, including advice about the value of diversification and ways of measuring risk. It will also help you decide for yourself whether to believe EMT. That is important because if you believe in stock market efficiency, you will adopt a style and philosophy of stock investing very different from the one you will be smart to adopt if you do not.

Investors who have already concluded that EMT is not the best account of how stock market work could skip this chapter without being cheated, but even they may discover ways in which EMT has unwittingly affected their investing habits. All readers will also dis­ cover that the history of EMT is fascinating. It is a story about re­ search designed to enlarge knowledge, to explain and understand the world, research whose results are intermittently neglected and then overblown. The story tells us that EMT is not the last word on how stock market work, even though the power it has had over investors and teachers for several decades sometimes makes it seem that peo­ ple think it is the last word.

EMT traces its history to the random walk model of stock trading, the sensible idea that stock prices move in a way that cannot be predicted with any systematic accuracy. The model dates back to 1900, when it was elaborated in a doctoral dissertation by the French mathematician Louis Bachelier that though obscure in its time is now famous. That dissertation investigated linear correlation in the prices of options and futures traded on the French Bourse and con­ cluded that such price changes behaved according to a random walk model.

Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use Bachelier's work was not widely noticed when it was published, perhaps because the mathematical parts of it preceded by five years Einstein's famous work on the random motion of colliding gas molecules. Einstein "discovered" the equation that describes the phenomenon of random molecular motion, known as Brownian motion (after the Scottish botanist Robert Brown, who first observed it), which was precisely the equation Bachelier developed to describe price behavior in financial or stock market.

Although the mathematical properties Bachelier employed were of direct and immediate interest to physicists and mathematicians (including Einstein and his intellectual progeny), economists paid little attention to the subject until the middle of the century. Indeed, virtually no studies before the early 1950s made any reference to Bachelier's work or to the theory of random processes in financial markets.

Maurice Kendall is frequently credited with bringing the random walk model to the attention of economists in the early 1950s. Bachelier's work itself, however, was not "discovered" by economists until they stumbled across it in the mid-1950s.

stock symbol ~ money maker
london stock exchange ~ foreign exchange trading
investing in stock ~ global forex trading
hot stock ~ money magazine  

While rummaging through a library, Leonard Savage of the University of Chicago happened upon a small book by Bachelier pub­ lished in 1914. He sent postcards to his economist friends asking if they had "ever heard of this guy." Paul Samuelson could not find the book in MIT's library but did locate and then read a copy of Bach­ elier's doctoral thesis. Just after Samuelson's discovery in 1959, the random walk model became a very popular area of research.

Bachelier's long obscurity was also due to a widely reported 1937 study by the renowned economist Alfred Cowles concluding that stock investing did move in a predictable way. This study shut down research on the random walk model for decades until in 1960 the Stanford professor Holbrook Working discovered a mistake in it. Cowles then corrected the mistake, and his revised study supported the random walk model.