One of the single biggest fallacies foisted upon the investing public is the notion of an “efficient market.”

Academics love it, which is why the “efficient-market hypothesis,” or EMH, as it’s known, is taught at all the leading B-schools. The broadest version of this theory holds that securities prices already reflect all known information; EMH proponents believe it’s impossible to outperform the markets over time - except by luck.

The reality, however, is that the markets are anything but efficient. In fact, not only are the markets highly inefficient, but - as many investors have learned the hard way - they are frequently completely irrational, as well.

First published in 1965 in The Financial Analysts Journal, the efficient-market hypothesis was the result of a nonsensical doctoral thesis penned by Eugene Fama. He hypothesized that the markets are characterized by multiple participants acting in a rational manner in an effort to profit. Fama believed - as the majority of EMH proponents do - that in an efficient market, competition among the participants leads to a situation where the actual prices of individual securities (stocks, bonds, exchange-traded funds, and the like) already reflect the combined total of all known information.

The bottom line: Stock prices, therefore, reflect reasonable intrinsic values at all times. [One version of the efficient-market hypothesis, the so-called "strong" version, actually holds that securities prices reflect all information - even information known only to company insiders, and to no one else out in the marketplace].

Few people understand that the belief in market efficiency - as much as any other factor - is one of the single-biggest justifications for all sorts of things that we take for granted today, including:

• Mark-to-market accounting systems.
• The concept of total returns.
• Efficient frontiers.
• And even various stock-rating systems.

Market efficiency even provides the underpinning for the so-called “prudent man” rules that are so critical to ERISA (Employee Retirement Income Securities Act of 1974) funds and the entire money-management industry, not to mention much of the Financial Accounting Standards Board (FASB) regulations.

Well, at the potential of really igniting an e-mail bonfire, we need to ask ourselves: If the markets are truly this efficient, why do all the research? Why would we have an entire industry of analysts who are collectively paid billions of dollars a year to ferret out information that the efficient-market hypothesis says is already reflected in current market prices? In fact, why would we even have the concept of “insider trading” to deal with or be so concerned by American International Group Inc.