“If the world was perfect, it wouldn't be.” – Yogi Berra
My opinions about the Efficient Market Hypothesis (EMH) are not necessarily worth more than anyone else’s, but I have been reading and researching EMH for years. I’ve also heard many informed opinions about it.
I would have to say I believe in the “Weak EMH”. Why? There is a lot of evidence that markets are relatively efficiency and assimilate new information very quickly and usually effectively. EMH cannot be dismissed completely.
However, while most information is available to everyone, most investors make investment decisions based on very little information and often make their decisions primarily on emotional factors. The cognitive errors outlined in behavioural finance explain much of what really happens in the markets. Even professional investors are still human and also fall into these same traps.
Weak EMH claims that all technical analysis (charting) does not work except by luck. I believe that this is true for the most part. We’ve seen many people selling charting strategies, but have seen very few verifiable examples of anyone making a good return from them.
I think that someone sees a pattern that probably does not actually exist. Most patterns we see as humans don’t actually exist. Random stock movements will usually look like a pattern when you study them. Then a bunch investors start to see it and invest by it, which makes the pattern actually happen. Then more people find out about it and recognize the pattern and buy more quickly, which makes the pattern stops working. Once it stops working, then someone who saw it work for a bit starts to market it. (If it worked very well, nobody would market it. They would keep it to themselves.)
From what we’ve seen, the next level of “Semi-strong EMH” is doubtful. It would claim that fundamental analysis does not work, but we’ve seen too many examples of fundamental analysis working. All the exceptional fund managers mentioned in part 2 use fundamental analysis as part of their value style of investing. They study a company to figure out what it is really worth and only buy when they can get it 30-50% below that value.
Part of what we do as financial advisors is to constantly evaluate mutual and hedge fund managers to identify the very best and smartest for our clients. One of the most informative pieces of info is what a fund manager thinks of EMH. Fund managers that beat the index often have very insightful opinions on why they beat the index. Of course, many don’t or have opinions that probably come from something they read. Fund managers that don’t beat the indexes often dismiss EMH or claim the indexes are too risky for their investors.
For example, one of our fund managers is a value style investor that claims most stocks are mispriced most of the time. They work out what companies are really worth and claim most stocks sell noticeably above or below their real intrinsic value. They claim that the market tends to value currently popular companies well, but stocks that are out of favour often sell for much less than they are worth. This is a systematic market inefficiency that they claim to be able to take advantage of consistently (and their performance backs this up).
Another of our fund managers believes the market indexes are really a mutual fund run with specific principles. The index buys large liquid companies, has very little turnover, and dumps its losers and holds its winners – all of which generally work. Most mutual fund managers do the opposite of these. However, the indexes do very little research and so they often own bad or inferior companies. This fund manager systematically beats the indexes by doing what indexes do right and not what they do wrong.
Another fund manager believes there are many, many markets – not just one. Different markets are efficient to different degrees. The US has the most efficient stock market, with many other countries, especially emerging markets being much less efficient. Large cap stocks tend to be more closely followed and so are more efficient than small cap stocks. IPO’s are usually heavily marketed and there is usually less info than with established companies, so IPO’s are less efficient than the broad stock markets. This fund manager beats the indexes by buying undervalued companies and focusing on less efficient markets.
Top fund managers often have these types of profound insights into the EMH and the systematic inefficiency that allows them to beat the index. This is why I don’t believe the “Semi-strong EMH” or “Strong EMH”. Fundamental analysis of stocks quite often produces better returns – much less than half the time but enough to prove it can be systematically done.
Much of the time, top performers were just lucky or their style just happened to be in favour, as EMH claims. However, a few skilled investors can identify and take advantage of systematic inefficiencies in the markets and are disciplined enough to take advantage of them.
Now that you have a general understanding and possibly an opinion on EMH, how does this affect your philosophy about how to invest effectively?
Thanks to Ed Rempel for another thought provoking series of articles. If you have questions, feel free to leave them in the comments.If you would like to read more articles like this, you can sign up for my free newsletter service below (we will not spam you).