Is the Market Efficient? – Part II
“I never blame myself when I'm not hitting. I just blame the bat, and if it keeps up, I change bats. After all, if I know it isn't my fault that I'm not hitting, how can I get mad at myself?” – Yogi Berra
Let’s take a closer look at the Efficient Market Theory (EMH). Are the markets efficient?
Many amateur and even professional investors dismiss it quickly, but it is clear there is evidence that the stock markets are relatively efficient. As mentioned in part 1, professional and amateur investors usually make considerable less than the markets.
When there is a takeover offer for a company, the price of that company’s shares almost immediately reflect the takeover price (less an amount because of the time until the takeover happens and less the degree of doubt as to whether the takeover will happen). This price adjustment shows market efficiency.
On the other hand, there is also clear evidence that EMH is not totally true. Index enthusiasts argue that all information is available to all investors and that they have rationally built it into the current share price. Therefore, the extreme belief would mean that throwing a dart at the stock page will be equally effective to all investment strategies. Their argument for owning the index is that you own “all of the market” (which is not really true), but their real belief is that any stock would be expected to have the same returns as the index (taking into account the risk level).
If you meet an EMH fanatic, just suggest that they throw a handful of darts at the stock pages instead of buying an index, and you will find they don’t really fully believe in the EMH after all.
The best arguments against the EMH come from the field of behavioural finance. EMH cannot explain market manias. It believes that all investors are always rational, but there have been many examples in history of “irrational exuberance” or irrational pessimism.
For example, the crash of 1987 saw the markets drop by more than 20% in a few days with little news. Seeing the large drops, investors dumped their stocks in panic selling. If you believe an investment is fairly valued, then how can you argue that panic selling as it falls is rational behaviour?
Here in Brampton, we saw our local company Nortel fall from $123.50/share to $.69/share in just over 2 years. EMH would argue that both prices were accurate based on known information. How can that possibly be? In hindsight, it is clear that it was never worth anywhere close to $123.50. This was part of the “tech bubble” with investors having piled into Nortel for a few years only because it was going up as it continued to rise and outperform almost all other investments. And $.69/share was equally ridiculous, with investors finally capitulating and dumping Nortel in mass.
Behavioural finance shows that many cognitive and emotional biases often result in prices selling for much higher or lower than they are really worth. As humans, our minds search for patterns and we see all kinds of patterns that don’t actually exist (clustering bias). We tend to be over-confident, anchor on past numbers, interpret data based on our preconceived views, feel safer following the herd, see things differently in hind-sight and fall prey to many other cognitive biases. (It is worth reading about behavioural finance, because then you will find listening to your investing buddies quite funny! People hate it when you name their investing cognitive bias!)
Humans also tend to often make decisions for emotional reasons. How often have you heard someone say they bought an investment because a “gut feeling” or “it feels right”? Is this rational behaviour? Irrational exuberance and panic selling are clearly emotional reactions and not rational behaviour, as EMH would argue.
The other big argument against EMH is the investors that beat the indexes by wide margins over long periods of time. EMH does claim, however, that by luck and with a normal distribution, a few investors would beat the markets by wide margins.
It is hard to put much faith in claims of spectacular returns by some amateur investors. They can usually not be independently verified, and studies show most amateur investors vastly miscalculate their own returns (if they calculate them at all). In addition, it is very difficult to find evidence that it was not just luck.
However, there are quite a few examples of professional fund managers beating the indexes by wide margins over long periods of time. Investors such as Warren Buffett, George Soros, Peter Lynch and Bill Miller have beaten the markets by such wide margins over long periods of time that the odds of it being luck are astronomical. These returns are verifiable public information.
There are also quite a few exceptional long term value investors. Value stocks and growth stocks tend to have similar long term returns, with each having their periods in favour. We recently had growth trounce value from 1995-99 so that all value style investments seemed boring and everyone wanted tech and all the high growth sectors. From 2000-2006, value has totally dominated so much that growth investing seems ridiculous and everyone wants resources, cyclicals, financials and dividend stocks. Now in 2007, it appears that growth is starting to take over again.
Value and growth have their cycles and similar long term returns. However, when you look at the long term exceptional investors, they are almost all value investors. For example, Rick Guerin managed the Pacific Partners fund from 1965 to 1983 (19 years) and averaged 32.9%/year while the S&P500 index made only 7.8%. He beat the index by more than 25%/year! Then there were Walter Schloss, Tweedy Browne, Charles Munger, Bill Ruane and quite a few more recent fund managers.
The unique point here is that all these managers are value style. The other 2 main investing styles, growth and momentum, rarely have a manager with long term large index-beating returns. This fact would seem to point to a systematic market inefficiency. The EMH cannot explain it.
In part 3, I’ll discuss my own humble opinions about EMH.