There are basically two competing views in the investment world today. One side contends that markets do not work and an investor can take advantage of “mispricings.” The other side contends that markets do work, looking for mispricings is not worth the trouble, and you are better off being the market instead of trying to beat it. These two views are known as “active” and “passive” respectively. Which school of thought an investor falls into depends upon their views on whether or not markets work.
To say that markets work assumes one thing: they have a job to do. Their job is to value assets and offer a forum of exchange between willing participants. It is in this way that capital (money) can be moved towards its highest and best use. It allows for an innovative business to raise funds and expand operations. At the same time, it forces unproductive businesses to go out of business. The question is how well do markets do this? How well do prices accurately reflect values?
A long time ago, investment success was based on knowing what others didn’t. In that environment it was to your advantage not to diversify and watch your positions closely. Since then, regulations have mandated that information be made available to all market participants at the same time, thus creating the distinction between public and non-public (insider) information.
This introduces the central debate in the investment industry today: Market Efficiency. It is perhaps the most misunderstood concept in investment theory. The Efficient Market Hypothesis was developed by a University of Chicago professor named Eugene F. Fama in 1966, the same year Simon & Garfunkel released Sounds of Silence. It was at this time that technological developments allowed for the study of decades of stock price patterns. The basis of the hypothesis is that markets are informationally efficient. Security prices adjust rapidly to new information and security prices reflect all known information about the security.
In a truly efficient market, the best estimate of tomorrow’s prices is today’s prices. In order to beat the market you have to either take on more risk or get lucky (luck generally applies to an undiversified portfolio).
There is a joke about an economics professor and a student walking down the street. The student says to the professor, “Look there’s a $10 bill on the ground.” The professor replies “Don’t bother, if that was a real $10 bill, someone would have picked it up already.” The joke is used to criticize the Efficient Market Hypothesis. However, the hypothesis implies that there are bound to be a few $10 bills lying around, but you wouldn’t want to make a living out of finding them because generally they don’t stay there for long.
I have been laughed at by a hedge fund manager for saying markets are efficient. When he said “you must be crazy, markets aren’t efficient,” I asked if he considered himself good at his job. He said “yes,” and I followed with, “then you must help to make markets efficient.” I tried to rationalize his thought and came to the conclusion that he must think that if a stock goes down in value then the market must have gotten it wrong. If he buys a stock at a low price and it goes up the market must be wrong, whereas he got it right. The misconception is that just because stocks go up or down and you can make money off of it doesn’t mean the market is inefficient. Stocks go up and down because the market is efficient. There is a constant flow of new information coming out and that new equilibrium between buyer and seller is constantly changing. I bet investors who bought Bank of American at $3.50 last March are feeling pretty smart, I would too. Does that mean the market was inefficient to let the stock price go that far down? No. What was the information then? It was that they had a good chance of being out of business soon.
A second misconception investors make is that there are certain anomalies that disprove the hypothesis. The two most popular are the Price-to-Earnings Ratio Effect and the Book-to-Market Value Effect. The presumption is that if you buy value stocks (those with low price to earnings and high book to market ratios), you will outperform the market. What they fail to realize is that these companies are riskier; much like Bank of America was in March. Therefore they have a higher expected return than the overall market.
In my mind The Efficient Market Hypothesis appears to be a simple truism and not a theory up for debate. Certainly there are markets that are less efficient than others and some investors seem to be able to consistently beat the market. But how much of that is chance, risk, or information based? And how much does that research cost? As we will explore later, The Efficient Market Hypothesis is merely a model, a simplification of a very complex world, but a very useful one when it comes to individual investors.
Myles B. Brandt, CFP®