The patron saint of the Bolsa (stock exchange) in Barcelona, Spain, is Nuestra Señora de la Esperanza—Our Lady of Hope. She is the perfect patroness, for we all hope for superior returns when we invest. But competition between investors will tend to produce an efficient market. In such a market, prices will rapidly impound any new information, and it will be difficult to make consistently superior returns. We may indeed hope, but all we can rationally expect in an efficient market is a return just sufficient to compensate us for the time value of money and for the risks we bear.

The efficient-market hypothesis comes in three different flavors. The weak form of the hypothesis states that prices efficiently reflect all the information in the past series of stock prices. In this case it is impossible to earn superior returns simply by looking for patterns in stock prices; in other words, price changes are random. The semistrong form of the hypothesis states that prices reflect all published information. That means it is impossible to make consistently superior returns just by reading the newspaper, looking at the company's annual accounts, and so on. The strong form of the hypothesis states that stock prices effectively impound all available information. It tells us that superior information is hard to find because in pursuing it you are in competition with thousands, perhaps millions, of active, intelligent, and greedy investors. The best you can do in this case is to assume that securities are fairly priced and to hope that one day Nuestra Señora will reward your humility.

During the 1960s and 1970s every article on the topic seemed to provide additional evidence that markets are efficient. But then readers became tired of hearing the same message and wanted to read about possible exceptions. During the 1980s and 1990s more and more anomalies and puzzles were uncovered. Bubbles, including the dot.com bubble of the 1990s and the real estate bubble of the 2000s, cast doubt on whether markets were always and everywhere efficient.

Limits to arbitrage can explain why asset prices may get out of line with fundamental values. Behavioral finance, which relies on psychological evidence to interpret investor behavior, is consistent with many of the deviations from market efficiency. Behavioral finance says that investors are averse to even small losses, especially when recent investment returns have been disappointing. Investors may rely too much on a few recent events in predicting the future. They may be overconfident in their predictions and may be sluggish in reacting to new information.

There are plenty of quirks and biases in human behavior, so behavioral finance has plenty of raw material. But if every puzzle or anomaly can be explained by some recipe of quirks, biases, and hindsight, what have we learned? Research in behavioral finance literature is informative and intriguing, but not yet at the stage where a few parsimonious models can account for most of the deviations from market efficiency.

For the corporate treasurer who is concerned with issuing or purchasing securities, the efficient-market theory has obvious implications. In one sense, however, it raises more questions than it answers. The existence of efficient markets does not mean that the financial manager can let financing take care of itself. It provides only a starting point for analysis. It is time to look at the principal financing decisions.