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Is the Market Efficient? – Part I

Ed Rempel, a CFP and CMA, has written another guest post.  This time, the subject is on the equity markets and their efficiency.  It's a fairly long post, so get comfortable.  This is Part 1 of a 3 part series. 

“You can observe a lot just by watching.” – Yogi Berra

The Efficient Market Hypothesis (EMH) has been widely discussed by many market experts. Understanding it and having an opinion on it is very important for any investor. If you want to develop your own belief about how to invest effectively, having an informed opinion on EMH can be very helpful.

Those who believe in index investing or who market ETF’s are the biggest supporters of EMH, as are most market academics and many newspapers columnists. Most of the top investment managers have specific opinions on EMH and those that beat the indexes over time can almost always tell your why.

EMH has been subject to a lot of hype and marketing. Is the market efficient?

I won’t bore you with an in depth description. The basics, however, are that EMH maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally. In other words, there are millions of investors that all have access to all available information about any company and these investors make rational choices of which stocks to buy based on all this available information. Therefore, all stocks are always priced accurately.

When new information becomes available about any company, it is immediately available to all investors who quickly assimilate it with all other information and adjust the stock price accordingly. This means that all stocks are priced correctly all the time and future price movements result from new information that cannot be anticipated from existing known information. Therefore, future price movements are a “random walk”.

The main evidence to support EMH is that most investors do not beat the market. Many studies have shown this. The most popular is usually the Dalbar study that is updated every year. It is now a 20-year study and shows that over the last 20 years, the S&P500 has averaged 13%/year, the average mutual fund (professional investor) has averaged 11%, the average investor (amateur investor) has average 3.5% and the average market timer has averaged a loss of 3.5%. Most of the time, only 20-45% of mutual funds beat their index (depending on which time frame and which index). Clearly, the methods of most investors (professional or amateur) are worse than the market averages.

There are 3 levels of EMH based on the types of information that are fully accounted for in existing share prices:

Weak EMH: All historical market prices and financial data are known to all investors, so no investor can get better returns from analyzing them. This means that all technical analysis (charting) will not work except by luck. Fundamental analysis to figure out the true value of companies can still produce better returns, however.

Semi-strong EMH: All public information about all companies is known to all investors, who are rational and unbiased. This means that fundamental analysis of stocks also cannot produce better returns except by luck. However, insider information or on-site visits could still provide information to produce better returns.

Strong EMH: All public and insider information is known to al investors. Insider information leaks out and laws prevent insiders form using it, so even insider information cannot produce better returns except by luck. Therefore, no strategy or investment method can produce better returns except by luck. A monkey can then pick stocks as well as Warren Buffett.

The big question whenever we hear about any investment strategy or the returns of any investor is: How do you know it is not just luck? EMH claims that future returns from any strategy will fit into a “normal distribution” of possible returns. Whenever you look back, some strategy will have worked better than others, and those that believe in it will claim it was skill (hindsight bias). In fact, since the markets usually rise about 70% of the time, EMH claims that essentially all strategies should work about 70% of the time over the long run.

Market theorists and university professors, of course, tend to believe it, since it is intellectual and relatively simple.

Newspaper columnists often like EMH, usually because it is simple and because it is much more difficult to effectively recommend specific investments. If nobody can beat the market, then the only important factor in investments is the cost of trading or the MER of a fund, which is a very simple concept. Jonathan Chevreau has written hundreds of articles about how nobody can beat the market – so just buy ETF’s.

Professional investors, or course, generally disagree with EMH, since it means that none of them are any better than anyone else. Many dismiss it as ridiculous, but many others have very valid criticisms.

Many amateur investors don’t believe in EMH, usually because of a lack of understanding about it. Most people think they are smarter than average and better investors (and drivers) than average, while EMH claims that the only reason anyone gets better returns is dumb luck. Folklore about the amazing returns of some amateur investor and dreams of making big money fuel this. “If Joe’s brother-in-law can do it, then I so can I…”

Many amateur investors (if they know about EMH) often falsely believe that EMH means the current price of a stock reflects the future returns that stock will actually make. EMH does not claim that all future information is built into existing stock prices. It claims the likelihoods of all possible future outcomes are taken into account in current share prices. EMH also does not claim that investors act randomly – only that share prices move randomly since they result only from investors reacting to new information as it becomes available. This new information could be about the company, the market, the economy, political events or anything else that might affect the value of a company’s shares and cannot be anticipated.

In part 2, we’ll have arguments for both sides and my personal humble opinion. What do you think – are markets efficient? Is all information available to all investors? Do investors actually access this information and understand it before making investment decisions? Are investors rational? (By the way, if you really understand EMH, I doubt you will either dismiss it completely or believe it completely.)







18 Comments, Comment or Ping

  1. I personally do not believe in the EMH. People are too emotional and irrational to make the correct decision on the valuation of a company. This is why technical traders/chartists can make money on the markets.

    Information is only part of the equation as to why people buy/sell stock. The other part of the equation is human emotion (greed/fear).

  2. Very interesting post. Ed, I will predict that your “humble opinion” will say that your beliefs lie somewhere between the weak and semi-strong version of EMH – closer to the semi-strong.

    I am very skeptical about the Dalbar study – they are a company that provides services to dealers & advisors companies and have an interest in promoting the idea that all investors need an advisor to prevent them from losing money. I’ve read a version of their report and there was no information as to how they calculate their findings. This is just my opinion but I have a hard time believing that the average investor would only get one third of the market return. Are there that many investors chasing returns and selling at the bottom of the market?

    As for your questions: I believe the market is relatively efficient – somewhere between semi-strong and strong.

    One of the central points that Malkiel makes (Random Walk Down Wall Street), which I tend to agree with is that he believes that although the market is not perfectly efficient (nothing is), it’s impossible for an investor to take advantage of any inefficiencies long enough to make significant money because other investors will soon discover that same inefficiency and it will disappear.

    One other thing I’d like to mention is that I am perfectly open to believe that someone can beat the market on a regular basis but I need some sort of proof. I’ve mentioned to more than a few bloggers who are active managers (like FT) that they should measure their performance and determine how much value their active management is adding. As far as investors or advisors (like you) who say they can pick mutual funds that beat the market – where’s the beef? I want to see some numbers.

    Mike

  3. Great post Ed! I’m looking forward to the next 2 parts. There are some great points that you make in that people should look at the theory and then decide their belief (or degree of belief).

    I think markets are getting more efficient over time, but will never be THAT efficient that anyone who outperforms the market will have done so based solely on luck.

    I’m not 100% sure on this, but is EMH responsible for calling Warren Buffett a 5-Sigma event? If so, how do they explain Bogle, Soros and Rogers? Can you have 4 different 5-Sigma events in our lifetime? If not, then this is a strike against efficiency.

    I might be citing incorrectly, but I think Richard Charlton wrote in his book “Investing the Billionaire’s Way” about a story that helps solidify Buffett and Graham’s Mr. Market:

    Let’s say there were 10 friends who bought a $100,000 banquet hall (each for a $10,000 stake and 10% ownership) and managed to turn a 10% profit in their first year. Each following year they managed to increase the profits and let’s say that the real estate prices were increasing as well. After some years it would be expected that the banquet hall might now be worth, say, $300,000 (through the increase in real estate and the increased value of the operation of the business).

    Well, let’s say that one of the partners was now getting a divorce and the court settlement stated that he had to provide a cash equalization payment to his wife. He does not have cash on hand, so he is forced to sell his share of the business. He goes to the other partners and asks for $30,000 for his 10% stake. Let’s say that he had fallen out of favour with the other partners as well (popular guy). They turn him down and won’t buy. He comes back a week later and offers to sell for $10,000 – and again they turn him down out of spite. They offer to buy his 10% stake for $5,000 and he agrees because he needs the money desperately.

    Well according to the way the stock market works – that banquet hall is now “worth” $50,000 since a company’s market cap is determined by the value of the very last transaction on the market.

    But of course to the other partners – they believe it is worth $300,000.

    (I realize it is an EXTREME example – but it helped nail down the concept of intrinsic value versus market value to me when I was starting out). The ability to exploit this difference is how Buffett has been so successful for, what now, 6 decades?. As such, my belief is that a totally efficient market does not exist.

    Having said that I also concede that I am not smart enough to recognize the inefficiencies as well as I would like, and as such do subscribe to a high degree of indexing in my portfolios (coupled with *some* active management).

  4. Preet – I’m not sure how valid your example is (and I do realize it’s just a teaching example). Why does the partner have to sell to the existing partners only? If he does have to sell to them he should have a shareholder agreement that allows for independent valuation or shotgun clause etc. If he doesn’t have any other options then the problem is the shareholder agreement which has nothing to do with the markets. In that case the inadequate shareholder agreement has artificially created an extremely inefficient market.

    One thing about Buffett is that he doesn’t just buy shares in companies – he basically takes them over which is apples and oranges compared to you and I buying our 50 shares.

    I agree with your conclusion.

  5. 5. Telly

    Great post and some very good discussions thus far. I believe it’s very beneficial to ask yourself this question (“how efficient, if at all, do you think the markets are?”) on a regular basis to make sure that your portfolio reflects this and that you haven’t changed your strategy. Thanks for the reminder…

    I’m in the weak to semi-strong camp myself. Though I don’t believe humans to be totally rational collectively, I also believe charting to be a poor process for stock selecting.

    Looking forward to the next two parts in this series.

  6. Hi FourPillars – you are totally right – it’s probably on the borderline of completely invalid in the real world for the points that you mention. I just found it to be a great way to first learn how pricing inefficiencies can arise and why you need to have your own belief as to the intrinsic value of a company versus the market value and to understand that the two are the same for very brief periods of time.

    Buffett is certainly an anomaly. And it can be argued that there is another factor affecting his success for the latter half of his career – the propensity of people to buy what he is buying because he is Warren Buffett. You gotta believe these days that when he announces he is making a transaction it further reduces the risk of the transaction based on his credentials inviting others to make the same transaction.

    Also, to add to your comment about Buffett buying whole companies – I think he and Lynch have both said that you should act as if you are buying the entire company when you buy even one share of a company – and as such, do the same amount of research, due diligence, etc. i.e. the only thing stopping you from buying the whole company should be your lack of funds – if people were to take this amount of discipline when buying stocks as when they are evaluating whether to buy a company outright – they may only buy a handful in their lifetimes.

    He would argue that buying 50 shares or 50 million shares should indeed be apples to apples. Of course in reality… you certainly have a point too. 50 shares does not give you much of a voice in a company’s shareholder meetings… :)

  7. 7. Jonathan

    I tend to agree with FT. My biggest problem with EMH is that it assumes all market participants are rational. My primary trading method is predicated on the fact that people make mistakes in trading, just like they do in every other area of life.

    These screw ups(certain types of gaps)are great examples of inefficiencies that are tradeable.

    Great subject, btw. Looking forward to part 2 and 3.

  8. 8. blogger

    My belief is “Markets are quite efficient”. Sometimes the inefficiency can be large and spread across all of market. So I try to index and stick with market for the bulk of my portfolio and look for occasional inefficiency and exploit it.

    Warren Buffet said: If markets were efficient, then I would be a bum on the streets of NY.

  9. 9. Chris

    Academia (and the like) claim that markets are efficient and argue that if a person or firm can develop a winning system on a computer, so could others, and we would all cancel each other out.

    So what’s wrong with this logical argument?

    Well, people develop these systems and people will ALWAYS make mistakes.

    Some will alter their system and jump from system to system as each one has a losing period.

    Others will be unable to resist second-guessing the trading signals

    People will never change as human psychology always stays the same, therefore, patterns will exist and the markets will never be random.

    You should be getting the point by now: Humans will NEVER change and markets will form patterns and form booms and bust forever! We (the mass majority) don’t learn from the past because we didn’t live in the past so we will always make the same emotional mistakes regardless of the technological advances in trading.

    If markets were efficient, no one and I mean NO ONE could sustain consistent returns in the market year after year. Traders such as Hite, Seykota, Marcus and others would have never been able to make returns of 30% or greater for extensive periods of time (20+ years in some cases). If we were trading random markets, a new master trader would prevail each year, leaving the others to random chances for success. It would be a crap shoot and expectancy would be thrown out the window because nothing would be consistent.

  10. 10. Ed Rempel

    Hi FP,

    Good comments and good point about measuring your performance against an index.

    As to your doubt about the average investor getting only 1/3 of the market, I’ve seen quite a few studies that support this.

    For example, there is the study about Fidelity Magellan fund (in the US). While being managed by Peter Lynch, the fund averaged more than 20%/year for those 15 years. The average investor in this fund, however, lost money. How can you lose money by investing in a fund that makes 20%/year for 15 years?

    Every time the fund had a good run, investors piled in. Then when it was down, they dumped it. The majority of the investors lost money. Conclusion? The vast majority of investors just chase returns.

    I also saw one study of all transactions done in a discount brokerage firm. They looked for all cases where the investor sold an investment and then bought another one within 30 days. Then the tracked the future returns of the investment sold vs. the investment purchased.

    I need to find this study again, but the conclusion was that the investment sold out-performed the new investment the majority of the time. It turned out that if nobody every traded anything, the total returns of all these investors would have been quite a bit higher.

    My opinion is that 70-80% of investors just chase returns. For anyone that doubts this, how many of your investors have had far below average performance recently? If your answer is none or hardly any, you are probably a performance chaser.

    Ed

  11. It’s easy to see why 80% of mutual funds underperform the index, because fund companies launch new products everyday to attract customers, not to beat the index.

    I believe the market is inefficient. You can find archives of commentaries from value investors screaming their lungs out just prior to the dot-com calamity.

    Nasdaq rose from 1000 to 4700 points in 2 years, and then fell to 1200 points in the next 2.5 years. Were investors investing by assimilating new information efficiently, or by reading the rear mirror?

  12. 13. Ed Rempel

    Hi FJ,

    Good comments. I mostly agree with you (as you will see in part 3).

    Your comment about fund companies launching products to attract customers, instead of beating the market is right on. That sounds like an excellent topic for a future article.

    Ed

  13. 15. Derek

    I will go in the NOT efficient category. This is because we have to many irrational traders, sometimes myself included, making dumb decisions at a high rate while trying for that holy grail.

    Having said that i also feel as Buffett does. For most of us its best to buy ETF’s since as stated above most managers care about making money… for themselves. An ETF has the lowest MER which means you will never beat or meat the market averages, but you will be very, very close.

    Stick to a plan, dollar cost average, and buy etf’s to beat most people. For the rest of us, which would be most posters here we want more. Thats why we need a proven system to pick stocks and i feel Graham’s is best. After all he taught Buffett and others who are the best!

    DH

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