The Efficient Market Theory (a.k.a. Efficient Market Hypothesis), says that markets are completely efficient and that all prices in the market already reflect the available knowledge and expectations of investors.
Subscribing to this theory means that no one is able to consistently beat the market and that index funds are your only hope of making money. The idea that you cannot beat the market was championed by Professor Burton Malkiel from Princeton University, who wrote A Random Walk Down Wall Street.
Let’s examine why I believe the Efficient Market Theory (EMT) is bunk:
1. Professor Malkiel admits that the stock market does “go crazy from time to time” in an interview with Geoff Colvin of Wall Street Week with FORTUNE. If markets are SO efficient, why do they go crazy? Can no one take advantage of this craziness? Was the tech bubble just a figment of my imagination? How about the housing crisis? Am I just dreaming right now?
Is the market NEVER mispriced? (If you subscribe to the Efficient Market Theory, your answer is yes.)
Here’s an analogy: A student and a professor who subscribes to the EMT on a walk to class, happen upon a $100 bill lying on the ground. As the student bends to pick it up, the professor says, “Don’t bother. If it were really a $100 bill, it wouldn’t be there.”
The interview referenced in the link above happened in 2003, when some businesses saw their valuations drop by as much as 90 percent. Admitting that the markets do “go crazy from time to time” seems to say that the market is generally efficient…except when it’s not. This is exactly what investors like Graham and Buffet have been saying for over 80 years.
2. The stock market is an emotional roller coaster. The fundamental numbers on a company can be rock solid on Monday and the stock can be priced at $50 per share. On Monday night, some bad news can come out on the industry and on Tuesday morning, the stock price can drop to $45. It’s earnings are still the same, the sales are still the same. The ROI is the same as is the cash flow and the shareholder’s equity. Nothing important changes, yet the price of the stock drops 10 percent.
Ben Graham once said that the market, in the long run, is a weighing machine, but in the short run is a voting machine. What he was saying was that in the short term, many stocks are priced on the basis of popularity by investors, but in the long run, the stock will be properly priced. That isn’t the EMT.
3. It is true that 95 percent of all mutual fund managers didn’t beat the market in the last 20 years. But you aren’t a mutual fund manager and you’re not judged by whether you beat the S&P or the Lipper Average. You’re financial skill will be measured by how comfortable you are at 80 years old. If the market declines by 40 percent but your mutual fund declines only 35 percent, your fund beat the average! Congratulations! Aren’t you happy?
When you read the interview, you’ll notice that Professor Malkiel admits to buying individual stocks and recommends avoiding high price to earnings multiples and make projections on where a stock will be priced in another decade or so. Interesting. Sounds like value investing.
From Beating the Street by Peter Lynch:
“I’ve said before that an amateur who devotes a small amount of study to companies in an industry he or she knows something about can outperform 95 percent of the paid experts who manage the mutual funds, plus have fun doing it.” – pg 19
And then later in the book:
“In every industry and every region of the country, the observant amateur can find great growth companies long before the professionals have discovered them.” – pg 30
What motivates you and what motivates a fund manager are two totally separate things.
4. There is a major difference between the institutional investor and the individual investor. About 85 percent of all stocks are held by institutions and pension funds. They ARE the market. By understanding how these large funds react and over-react to news and emotions, you stand to make a lot of money…and they DO over-react all the time. These funds have billions of dollars on the line. Does anyone really think that the fund managers don’t take the CFO’s and other company execs to Major League baseball games, PGA events, and the Superbowl? Does anyone really think they don’t go to fancy parties together and fancier restaurants? Does anyone think they don’t know the names of each of the exec’s children?
I’m not suggesting that anything illegal is going on, but if YOU had 40 million dollars invested in Company A, would you NOT be in touch daily with the goings on and the problems and challenges? Would you NOT work to develop a relationship with the PR department? When the head of PR refuses to take your call for 3 days straight, would you NOT be tempted to divest some of your funds holdings in that company, especially if you were hearing news that “something just wasn’t right?”
Have you ever watched a stock drop 15 percent, then clicked on the “latest news” tab, only to see nothing new for the last 3 weeks? We live in the real world where people are driven by incentives. Efficient Market Theorists live in some other world…I’m not sure which, but I think it could be in Orlando.
In 1984, Warren Buffet gave a speech to Columbia Business School, where he was invited to help commemorate the 50th anniversary of Security Analysis: The Classic 1934 Edition, written by Benjamin Graham and David L. Dodd. This book first introduced the ideas later popularized in The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition). In this speech, Buffet pointed out at least 20 other investors that used the “Graham Dodd Method” to select stocks. These investors had averaged between 18 and 33 percent annualized returns for 8 decades.
The point is, all of these investors used similar methods to select stocks and, contrary to Professor Malkiel, all of them weren’t managers of they companies they bought. The Professor believes that most of Buffet’s success comes from his taking the reins at the companies he buys. Intelligent Investors disagree.
Markets ARE NOT efficient as defined by the theory. The prices do not reflect everything known or believed at the time. For the Efficient Market Theory to work, the market must react rationally to all information. As anyone who has ever invested in individual stocks knows, the market is far from rational 100 percent of the time. If you can manage to identify those irrational periods (and you can), you stand to make a lot of money.
Here’s what others are saying:
Pinyo examines the Efficient Market Theory. The comments are worth reading too!
JLP of All Financial Matters reviews Wise Investing Made Simple and weighs in on his ideas on EMT.
Early Retirement Extreme examines the Efficient Market Hypothesis in detail.
Yeah, I think hypothesis is a better word. After all, some people think “theories” are scientific fact…