Perhaps no other theory in Investing has been proved right and wrong so many times in its history as Efficient market hypothesis, an idea that all the available information about a company is already reflected in the stock price. Therefore no one should make abnormal profits or losses when the price accurately reflects the inherent risk of a stock.

This economist column “The challenges to efficient-market theory” summarizes how the current market crash is precipitated by behavioral biases of investors.

There is now widespread acceptance that investors can behave irrationally, creating very large anomalies.

Belief in efficient-market theory made the authorities reluctant to restrain either the dotcom or the housing and credit bubbles. Perversely, the result has been much greater state interference in the markets than was dreamed of ten years ago,

The key point here is that a lot of market participants including regulators base their decisions assuming that the market fully and correctly reflects all the risks inherent in a stock. When the market is proved wrong they were already late.

But I started thinking is the efficient market theory really not practical in the real world? Data shows that low-fee Index funds (which rely on efficient market theory) have out performed many actively managed funds over longer time horizons. Let us take the case of an investor with a 10 year horizon. Should they invest just in a index fund and forget about it for 10 years. Should they have the funds actively managed while paying hefty fees that cut into the returns. It turns out that this will never be a easy choice for the investor.