[...] Is the Market Efficient? (Part 1 of 3) at Million Dollar Journey [...]

[...] on the efficient market hypothesis (EMH) which I thought was fantastic. There are three posts – Part I, Part II and Part [...]

[...] the Market Efficient?" series.  In case you missed the other articles, here you find Part 1 and Part [...]

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

[...] November FrugalTrader05:00 amAdd comment Ed Rempel continues his post about the Efficient Market Hypothesis.  This is Part 2 of 3.  If you missed Part 1, you can find it here.  [...]

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

[...] Million Dollar Journey featured a post on the Efficient Market Hypothesis. [...]

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?

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

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.

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

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.

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… :)

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.

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.

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).

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

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).