Efficient Market Hypothesis: Fact Or Fiction?

Published in Investing on 5 January 2012

Our economics series looks at the question of whether we really can beat the market.

How many times have you heard a would-be private investor saying something like: "You can't beat the game, because the big institutions always get the information ahead of you and get in first"?

If you believe that, you might be a proponent of the Efficient Market Hypothesis, which says that because the financial world is efficient in terms of information, it is impossible to consistently beat the market based on what you know when you choose where to put your money.

The idea was first developed by the economist Eugene Fama in the 1960s, following on from his observations that the day-to-day movements of the stock market resemble a random walk as much as anything else. And for a while, it came to be pretty much accepted as fact.

On the face of it, it does seem reasonable. Given that everyone has access to the same information, and there is a truly free price-setting equilibrium in which the balance of supply and demand is the determining factor in setting share prices (as it pretty much is with any free-traded commodity), surely the price will reflect all of the information available at the time, and you can't beat the market.

Fine in the short term

In the short term, the idea seems pretty much spot-on. New results are released and they look good, and you try to get in 'ahead of the market' to profit from them? Well, no matter how quick you are, it's too late and the price has already jumped. That's really no surprise, because the sellers of the shares have the same new information too, and the equilibrium point between supply and demand will instantly change.

But in the longer term, the Efficient Market Hypothesis is widely considered to be flawed. In fact, if you believed it held true over serious investing timescales, you probably wouldn't be reading this -- you'd have all your investing cash in a tracker fund and you'd be spending your spare time doing something else. (And that's actually not a bad idea at all, but it's perhaps something for another day).

There is plenty of empirical evidence that the market is what Paul Samuelson described as "micro-efficient" but "macro-inefficient", such that it holds true for individual prices over the short term but fails to explain longer-term whole-market movements.

Long term? Hmm!

And there are others, including the noted contrarian investor David Dreman, who argue that this "micro efficiency" is no efficiency at all, claiming instead that short-term response to news is not what investors should be interested in, but the longer-term picture for a company. It's pretty clear which side of that argument Foolish investors will come down on.

So why doesn't it work in the long run, and how is it possible to beat the market even in the presence of the ubiquity of news and an instantly adjusting price mechanism? Well, the major flaw is that the theory assumes that all participants in the market will act rationally, and that the price of a share will always reflect a truly objective assessment of its real value. Or at least that the balance of opinion at any one time will even out to provide an aggregate rational valuation.

It doesn't take a trained economist to realise what nonsense that can be. Any armchair observer who watched supposedly rational investors push internet shares up to insane valuations during the tech share boom around the year 2000 saw just how the madness of crowds can easily overcome calm rationality.

And the same is true of the recent credit crunch, when panicking investors climbed aboard the 'sell, sell, sell' bandwagon, pushing prices for many a good company down to seriously undervalued levels. What happens is that human emotion just about always outstrips rationality -- good things are seen as much better than they really are, and bad things much worse.

Irrational expectations

And it's not just these periods of insanity, either. There is, for example, strong evidence that shares with a low price-to-earnings ratio, low price-to-cash-flow ratio and so on, tend to outperform the market in the long run. And high-expectation growth shares are regularly afforded irrationally high valuations, and end up reverting to the norm and failing to outperform in the long term.

So what does that all say about the Efficient Market Hypothesis? Well, it certainly contributes to understanding how markets work, but we also need to include emotion, cognitive bias, short-term horizons and all sorts of other human failings in the overall equation.

And that means we can beat the market average in the long term, if we stick to objective valuation measures, don't let short-term excitements and panics sway us, and rein in our usual human over-optimism and over-pessimism.

http://www.fool.co.uk/news/investing/2012/01/05/efficient-market-hypothesis-fact-or-fiction.aspx

I don't understand why business schools don't teach the Warren Buffett model of investing.

I don't understand why business schools don't teach the Warren Buffett model of investing.


Or the Ben Graham model. Or the Peter Lynch model. Or the Martin Whitman model. (I could go on.) In English, you study great writers; in physics and biology, you study great scientists; in philosophy and math, you study great thinkers; but in most business school investment classes, you study modern finance theory, which is grounded in one basic premise--that markets are efficient because investors are always rational. It's just one point of view. A good English professor couldn't get away with teaching Melville as the backbone of English literature. How is it that business schools get away with teaching modern finance theory as the backbone of investing? Especially given that it's only a theory that, as far as I know, hasn't made many investors particularly rich.

Meanwhile, Berkshire Hathaway, under the stewardship of Buffett and vice chairman Charlie Munger, has made thousands of people rich over the past 30-odd years. And it has done so with integrity and a system of principles that is every bit as rigorous, if not more so, as anything modern finance theory can dish up.

On Monday, 11,000 Berkshire shareholders showed up at Aksarben Stadium in Omaha to hear Buffett and Munger talk about this set of principles. Together these principles form a model for investing to which any well-informed business-school student should be exposed--if not for the sake of the principles themselves, then at least to generate the kind of healthy debate that's common in other academic fields.

Whereas modern finance theory is built around the price behavior of stocks, the Buffett model is centered around buying businesses as if one were going to operate them. It's like the process of buying a house. You wouldn't buy a house on a tip from a friend or sight unseen from a description in a newspaper. And you surely wouldn't consider the volatility of the house's price in your consideration of risk. Indeed, regularly updated price quotes aren't available in the real estate market, because property doesn't trade the way common stocks do. Instead, you'd study the fundamentals--the neighborhood, comparable home sales, the condition of the house, and how much you think you could rent it for--to get an idea of its intrinsic value.

The same basic idea applies to buying a business that you'd operate yourself or to being a passive investor in the common stock of a company. Who cares about the price history of the stock? What bearing does it have on how the company conducts business? What's important is whether you can purchase at a reasonable price a business that generates good returns on capital (Buffett likes returns on equity in the neighborhood of 15% or better) without a lot of debt (which makes returns on capital less dependable). In the best of all worlds, the company will have a competitive advantage that allows it to sustain its above-average ROE for years, so you can hang on to it for a long time--just as you would live in your house--and reap the power of compounding.

Buffett further advocates investing in businesses that are easy to understand--Munger calls it "clearing one-foot hurdles"--so you can come up with more reliable estimates of their long-term economics. Coca-Cola's basic business is pretty staid, for example. Unit case sales and ROE determine the company's future earnings. Companies like Microsoftand Intel--good as they are--require clearing much higher hurdles of understanding because their business models are so dependent on the rapidly evolving world of high tech. Today it's a matter of selling the most word-processing programs; tomorrow it's the Internet presence; after that, who knows. For Coke, the challenge is always to sell more cases of beverage.

Buying a business or a stock just because it's cheap is a surefire way to lose money, according to the Buffett model. You get what you pay for. But if you're evaluating investments as businesses to begin with, you probably wouldn't make this mistake, because you'd recognize that a good business is worth buying at a fair price.

Finally, if you follow the Buffett model, you don't trade your investments just because our liquid stock markets invite you to do so. Activity for the sake of activity begets high transaction costs, high tax bills, and poor investment decisions ("if I make a mistake I can sell it in a minute"). Less is more.

I'm not trying to pick a fight with modern finance theory enthusiasts. I just find it unsettling that basic business-school curricula don't even consider models other than modern finance theory, even though those models are in the marketplace proving themselves every day.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/teachbuffet.htm

Following a systematic approach will help you overcome your psychological biases and know when you are making a judgement call.

To apply psychology in your stock buying and selling decisions, the first thing you should explore is your primary reason for making that decision.  

Consider a situation in which you decide to buy a stock because the stock's P/E ratio is low.  Knowing the primary reason for your decision, you should ask yourself:

Is buying a low P/E stock rational?

• There is plenty of evidence in the literature to suggest that in the long run, buying a low P/E stock results i higher-than-average returns.

Thus, your motivation appears rational.  You may have follow-up questions:

• Why is the P/E low? 

or

• What percentage of low P/E stocks actually outperforms the market within three years?

or

• How long should I hold a stock after I buy a low P/E stock?

Because you realize that you are not very patient, you may not like the answer that you should hold a stock for three to five years, and you may decide not to invest in low P/E stocks.

Systematic thinking will help you determine what you know or do not know and overcome your psychological biases.  When you do not know the answer, you need to make a judgement call.  

In the case of buying a low P/E stock, you might find that one possible reason for the low P/E is that the earnings are temporarily high.  

• It may not always be possible to gauge the extent to which earnings are temporarily high, and you may have to make a judgement call based on your knowledge of available financial data.  

In computing intrinsic value, we have to make estimates or judgement calls.  


Ultimately, everyone has to make judgement calls, but following a systematic approach will help you know when you are making a judgement call.

Related:

Strategies for Overcoming Psychological Biases

The field of behavioural finance highlights many psychological biases can impair the quality of investment decision making.

Commenting on selected KLSE stocks.

Portfolio tracking of selective KLSE stocks.
1. The severe bear market offers many opportunities.
2. One can buy good QVM companies at reasonable or bargain price.
The primary reasons for the motivation in March 2009 were rational.  The included stocks involve some judgement calls.

****Be a Better Investor

The barriers to success are psychological rather than physical.

Carefully examine the possible alternatives when you invest

Warren Buffett's Long-term timing of the market and the Rational Investing Model

I recently posted:

New Investing Idea: The Rational Investing Model is the alternative to the Buy-and-Hold Investing Model

and pleasantly received a reply from the author of the above article:

Rob Bennett said...

This is Rob Bennett, author of the Google Knol on "Why Buy-and-Hold Investing Can Never Work." Thanks for sharing some of the ideas set forth in the Knol with your readers, BullBear. If you or others have questions, I'm happy to help out to the extent that I am able. Rob

My comments:

Thanks Rob for allowing me to share your article in my blog.

Buy and hold strategy is safe for selected stocks.  Those using this strategy should be stock pickers; having only good quality companies in their portfolios and only buying them when their prices are obviously at bargain or fair prices.  Over the short term, the returns will be volatile, but over the long-term the returns on these investments will be predictably positive reflecting their fundamentals.

Though incorporating a long-term market timing based on valuation of the market may increase returns, like any market timing strategy, it may also impacts negatively on the returns too.

However, there are the very few periods when market timing can be usefully employed with a high degree of confidence and conviction.    Those with a good understanding of the valuation of the stock market can  employ this infrequently to their benefit when the valuations of the markets are obvious at the extremes.  Warren Buffett had done this on a few occasions in his very long investing lifetime.  In other periods (the majority of the time), buy and hold for the long term is safe and it works (my personal testimony), but for selected stocks only bought at bargain or fair prices. 

Investors would be impressed that Warren Buffett did make adjustments to his allocations to equities at certain periods during his long investing career.  These adjustments were based on valuations of the stocks and the market.  There were periods his exposure to equities were low when he felt the market was overpriced.  At one stage, he returned cash to all his investors as he could find no value in equities to justify continuing investing their money in stocks.  And there were the few occasions when Warren Buffett saw deep values in stocks and invested heavily, usually at the bottom of bear markets.  Yet, these were the times when other investors were most fearful.

What Warren Buffett did was essentially quite close to what Rob Bennett has written:

The Rational Investing Model encourages investors to take price (valuations) into consideration when setting their stock allocations.

Though we often hear only his "buy and hold forever" mantra, Warren Buffet has in fact been cleverly employing the equivalent of THE RATIONAL INVESTING MODEL, incorporating long-term market timing based on valuation of the market in his allocation of his money to stocks. 


The links below documented these actions by Warren Buffett:

*****Warren Buffett's commonsense approach to valuing the stock market

Buffett's success in gauging market conditions and profiting from them

Buffett: Keeping abreast of market conditions

*****Buffett's Shrinking Portfolio of the 1980s (1)

*****Buffett's shrinking portfolio of the 1980s (2)

Also read:

http://knol.google.com/k/why-buy-and-hold-investing-can-never-work#

http://www.getrichslowly.org/forum/viewtopic.php?f=2&t=4882
 
http://arichlife.passionsaving.com/2010/02/08/get-rich-slowly-forum-discusses-how-buy-and-hold-caused-the-economic-crisis/

http://www.retireearlyhomepage.com/bennett.html


and this:

A Better Approach to Investing from Rob Bennett of A Rich Life
I'd like to introduce you to a very solid approach to investing from Rob Bennett, author of A Rich Life. His investment approach has been given many names (the one I use for it is dynamic asset allocation). The principles are sound and over the long run, it will serve to reduce overall risk in your portfolio while providing more than adequate returns when compared to static or strategic asset allocation methods. To learn more, read on...
http://www.wealthuncomplicated.com/wealthuncomplicated/2009/05/a-better-approach-to-investing-from-rob-bennett.html

New Investing Idea: The Rational Investing Model is the alternative to the Buy-and-Hold Investing Model

The core Buy-and-Hold claim is that changing one's stock allocation in response to big price changes is not necessary for long-term investing success.

The Rational Investing Model encourages investors to take price (valuations) into consideration when setting their stock allocations.


History of Buy-and-Hold approach

Buy-and-hold approach is when investors maintain the same stock allocation at all times, irrespective of the market valuation.

Most middle-class workers have long had a fear of investing in stocks because of the big losses associated with this asset class at times of stock crashes. The promise of a scientific, long-term approach held great appeal. Few middle-class workers studied Buy-and-Hold to the extent needed to understand where the ideas came from or why they were supposed to work. But most quickly grasped the essential point being promoted -- this was responsible investing. Buy-and-Hold became popular because it was viewed as being a rejection of the Get Rich Quick thinking that had given much investment commentary a bad name.


Why Buy-and-Hold can never work.

It's easy today to explain why Buy-and-Hold can never work. The root idea is preposterous (but not obviously so to those who have not yet seen through it -- there are many smart and good people who possess a strong confidence in the concept). For Buy-and-Hold to work, valuations would have to have zero effect on long-term returns. Stocks would have to be the only asset class on the face of Planet Earth of which it could be said that the price paid for the asset has no effect on the value proposition provided. This cannot be. Price must matter. And if price matters, investors should not be going with the same stock allocation at times when valuations are insanely high as they do when stocks are fairly priced or low priced. Buy-and-Hold defies common sense.


The science of investing

The science of investing showed that short-term forecasting does not work and that a long-term focus is needed. The science appeared at the time to suggest that a Buy-and-Hold strategy (sticking to the same stock allocation at all times) makes sense.

The science did not prove that Buy-and-Hold works. The Greatest Mistake in the History of Personal Finance took place when the academics jumped to the hasty conclusion that the fact that short-term timing does not work necessarily leads to a conclusion that Buy-and-Hold is the only rational strategy.

But Shiller's 1981 research (confirmed by a mountain of research done since then) shows that overvaluation is a meaningful concept. Shiller showed that stocks offer better long-term returns starting from times of fair or low prices than they do starting from times of insanely high prices. Even many Buy-and-Hold advocates acknowledge today that valuations matter. William Bernstein says that valuations affect long-term returns as a matter of "mathematical certainty."

The market must ultimately be efficient, as the academics responsible for the Buy-and-Hold concept claimed. Yet the academic research of the past three decades shows conclusively that the market is not immediately efficient. What, then, is the full reality?

The full reality appears to be that the market is gradually efficient, not immediately efficient. It is investor emotions that determine market prices in the short term. But it is economic realities that determine stock prices in the long term (after the completion of 10 years of market gyrations or so). If the stock price rises too much higher than the price justified by the economic realities, opportunities open up for competing businesses to obtain the same assets on the cheap (relative to the market price assigned to them) and thereby to create a new business with the same profit potential as the overvalued one and thereby to pull the value assigned to it by the stock market down to reasonable levels. The market does indeed insure that stocks are priced properly. But it does not do this in an instant. The process can drag out for 10 years or even a bit longer.


What really works:  successful long-term investing requires long-term market timing

The strategic implications are earth-shaking. It turns out that we have been telling millions of middle-class investors precisely the opposite of what really works in stock investing. Since the market sets the price improperly in the short term and properly in the long term, successful long-term investing requires market timing (not the discredited approach of short-term timing, but long-term timing, which the historical data shows has always worked). The key to long-term success is to disdain the idea of sticking with the same stock allocation but instead always to be certain to adjust one's stock allocation as required by changes in the valuations assigned to the broad market indexes (only one allocation change every 10 years is required on average but it is essential that long-term investors make this change -- Buy-and-Hold never works in the long run because it argues that this change is not necessary or even that it is a good idea not to make the allocation change).


Discarding the Buy-and-Hold Era and adopting the Rational Investing Era

There is one step required before the transition from the Buy-and-Hold Era to the Rational Investing Era (The Rational Investing Model is the alternative to the Buy-and-Hold Investing Model -- it is described in some depth in articles and podcasts available at the http://www.passionsaving.com/ site) can begin in earnest. We need to persuade the many experts who advocated Buy-and-Hold to acknowledge the mistake and to thereby launch a national debate on what really works in stock investing. As of today, an institutional interest in preserving the status quo and avoiding the need to acknowledge mistakes has worsened the economic crisis and threatened to bring on a Second Great Depression.

We need a national debate on what works in stock investing. Buy-and-Hold advocates should of course be part of that debate. Buy-and-Hold advocates are smart and good people and have developed many rich insights despite the mistake they made about the core Buy-and-Hold claim (that changing one's stock allocation in response to big price changes is not necessary for long-term investing success). But we need a debate in which Buy-and-Hold advocates drop the pose of perfect understanding that has kept us from exploring new insights for so many years now. We need to see an openness to new investing ideas if our economic and political systems are to survive today's crisis. We need to rebuild optimism for the future by partaking in a fresh start in our effort to discover how stock investing works, We need to put aside those of the old rules that no longer work and replace them with better-informed new rules that do.


The Implication of moving from the Buy-and-Hold Investing Model to the Rational Investing Model

Many have lost sight of the point of investing analysis -- to help middle-class people finance their retirements. All this needs to change if our way of life is to survive the inevitable collapse of the Buy-and-Hold Model.

Our hope lies in coming to see the move from the Buy-and-Hold Investing Model to the Rational Investing Model (the Rational Model says that investors must consider price when setting their stock allocations) not as an investing question or an economics question but as a political question. We have a long tradition in this country of free speech. Free speech is permitted in our discussions of baseball and novels and nutrition and fashions. It should be permitted in discussions of the flaws of the Buy-and-Hold Model as well.


Summary

Buy-and-Hold can never work. But many of the insights developed by the smart and good people who brought us the Buy-and-Hold Model can do wonderful things to help millions when incorporated into a model that does work -- the Rational Investing Model, a model that encourages investors to take valuations into consideration when setting their stock allocations.


http://knol.google.com/k/why-buy-and-hold-investing-can-never-work#

http://arichlife.passionsaving.com/