---
type: claim
domain: mechanisms
description: "EMH fails not at the margin but at the foundation -- real markets exhibit herding, fat tails, and systematic irrationality that invalidate the mathematical framework"
confidence: likely
source: "Mandelbrot (fat tails, 1963), Kahneman/Tversky (prospect theory, 1979), Shiller (irrational exuberance, 2000), Soros (reflexivity, 1987)"
created: 2026-04-21
secondary_domains: [internet-finance, grand-strategy]
related_claims:
  - "information-cascades-produce-rational-bubbles-where-every-individual-acts-reasonably-but-the-group-outcome-is-catastrophic"
  - "hayeks-knowledge-problem-reveals-that-economic-planning-requires-both-local-and-global-information-which-are-never-simultaneously-available-to-decision-makers"
  - "the-shape-of-the-prior-distribution-determines-the-prediction-rule-and-getting-the-prior-wrong-produces-worse-predictions-than-having-less-data-with-the-right-prior"
---

# The efficient market hypothesis fails because its three core assumptions rational investors independence and normal distributions all fail empirically

The efficient market hypothesis (Fama, 1970) claims that asset prices fully reflect all available information. The mathematical framework requires three assumptions: (1) investors are rational expected-utility maximizers, (2) investors' errors are independent and cancel out, (3) returns follow normal (Gaussian) distributions. All three fail empirically.

**Rationality fails.** Kahneman and Tversky's prospect theory (1979) demonstrated that humans systematically overweight losses relative to gains, anchor on irrelevant reference points, and exhibit probability distortion. These are not random errors that cancel -- they are systematic biases that create predictable mispricings. The disposition effect (selling winners too early, holding losers too long) is observed across every market and every culture studied.

**Independence fails.** Real investors copy each other. Information cascades (Bikhchandani, Hirshleifer, Welch 1992) show that rational agents who observe predecessors' actions instead of using private information produce herding behavior. Soros's reflexivity (1987) goes further: market prices don't just reflect reality, they change it. A rising stock price improves a company's ability to raise capital, hire talent, and acquire competitors -- making the price rise "correct" in a self-fulfilling way until the reflexive loop breaks.

**Normal distributions fail.** Mandelbrot (1963) showed that cotton price changes follow Levy stable distributions with infinite variance, not Gaussians. The practical consequence: events that Gaussian models predict should occur once in the lifetime of the universe (like the 2008 financial crisis or the 1987 crash) actually occur every decade. Financial models built on normal distributions systematically underestimate tail risk by orders of magnitude. This is not a calibration error -- it is a category error in the mathematical foundation.

The EMH is not "approximately right." Its failure modes compound: irrational agents herd (combining failures 1 and 2), herding creates fat tails (combining failures 2 and 3), and fat-tail events trigger further irrationality (combining failures 3 and 1). The system is reflexive, correlated, and fat-tailed -- the three things the EMH requires it not to be.

## Evidence
- Mandelbrot (1963) -- cotton prices exhibit scaling behavior inconsistent with Gaussian assumptions; extended in Mandelbrot & Hudson "The Misbehavior of Markets" (2004)
- Kahneman & Tversky (1979) -- prospect theory replaces expected utility; Nobel Prize 2002
- Shiller (2000) -- excess volatility puzzle: stock prices are 5-13x more volatile than dividends justify
- 2008 financial crisis -- a "25-sigma event" under Gaussian assumptions, i.e., probability approximately zero
- Long-Term Capital Management (1998) -- Nobel laureates' fund collapsed because their models assumed independent, normally distributed returns

## Challenges
- The EMH remains useful as an approximation for liquid, well-studied markets over medium timeframes -- the failures are most extreme at short timescales and during regime changes
- Grossman-Stiglitz paradox (1980): if markets are perfectly efficient, there's no incentive to gather information, which means markets can't become efficient -- EMH is self-undermining
