What hope can there be for motivated stock pickers to outperform the low-cost index funds that simply mechanically track the market? Well – in spite of the absurd rise of the Nobel-acclaimed, and highly promoted, Efficient Market Hypothesis that claims that individual investors can’t beat the market – it turns out there is plenty! [Let me explain.] Words: 1574
The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article written by Stockopedia (www.stockopedia.co.uk)
The Claims of the EMH Concept
The Efficient Market Hypothesis (EMH) was first proposed in University of Chicago professor Eugene Fama’s 1970 paper Efficient Capital Markets: A Review of Theory and Empirical Work. To beat the market, stock pickers need to discover mispricings in stocks but the EMH claims that the market is a ruthless mechanism acting instantly to arbitrage away such opportunities, claiming that the current price of a stock is always the most accurate estimate of its value (known as “informational efficiency”). [Check out https://goo.gl/T2fnWj – Register for chance to win an iPad Pro!]
The EMH has evolved into a concept that a stock price reflects all available information in the market, making it impossible to have an edge. There are no undervalued stocks, it is argued, because there are smart security analysts who utilize all available information to ensure unfailingly appropriate prices. Investors who seem to beat the market year after year are just lucky.
A Dismissal of the EMH Approach
Despite still being widely taught in business schools, it is increasingly clear that the EMH is not held in high regard by the likes of Shiller, Buffett and Peter Lynch who have had this to say about it:
- “…one of the most remarkable errors in the history of economic thought” (Shiller)…
- “I’d be a bum on the street with a tin cup if the market was always efficient” (Warren Buffett)
- “Efficient markets? That’s a bunch of junk, crazy stuff” (Peter Lynch)
What’s So Bogus About EMH?
1. EMH is based on a set of absurd assumptions about the behaviour of market participants that goes something like this:
- Investors can trade stocks freely in any size, with no transaction costs;
- Everyone has access to the same information;
- Investors always behave rationally;
- All investors share the same goals and the same understanding of intrinsic value.
All of these assumptions are clearly nonsensical the more you think about them but, in particular, studies in behavioural finance initiated by Kahneman, Tversky and Thaler has shown that the premise of shared investor rationality is a seriously flawed and misleading one.
2. EMH makes predictions that do not accord with the reality.
a) Both the Tech Bubble and the Credit Bubble/Crunch show that that the market is subject to fads, whims and periods of irrational exuberance (and despair) which can not be explained away as rational.
b) Furthermore, contrary to the predictions of EMH, there have been plenty of individuals who have managed to outperform the market consistently over the decades.
Many… investors, such as Buffett or Benjamin Graham, have followed the value discipline, aiming to buy stocks for less than their intrinsic value, stubbornly refusing to get caught up in fashions and market whims, and sticking almost puritanically to their creed.
Others, such as George Soros or Bill O’Neill, have been nimbler, believing the market acts in predictable cyclical fashion from under to over exuberance, testing investment theses by pyramid-ing their trades and swinging for the fences when entirely confident in the outcome.
It is not only these professionals, recent publications have shown plenty of small private investors that have been consistently beating the market year in and year out.
Of course, it can be argued that these track records are merely the product of chance, that those beating the market are statistical “outliers” reflecting the sheer number of investors playing the market. However, Warren Buffett has countered this argument in a brilliant 1984 lecture entitled “The Superinvestors of Graham & Doddsville” in which he used the analogy of a national coin-flipping contest to explain the point, saying:
Imagine that tomorrow, 225 million Americans (or even orangutans) wake up and are asked to bet a dollar on a coin flip. Each day the losers drop out of the competition and the stakes build as all previous winnings are put on the line. After 10 flips on 10 mornings, the 220,000 players left in the competition would have won over $10,000. In another 10 days, the 225 left in the game would have turned their initial $1 stake into over $1 million.
It is true that, in this scenario, the group of coin-flippers will likely think themselves investment geniuses, whereas, in fact, they are the product of chance. Buffett pointed out, however, that there is some critical differences between this scenario of 215 lucky coin-flippers and the reality we face, namely the existence of shared characteristics of many of those successful money managers that cannot simply be explained away by chance…a common intellectual heritage, namely [that] they are value investors inspired by Benjamin Graham who search for discrepancies between the value of a business and the price of small pieces of that business in the market. [Buffett went on to say:]
In this group of successful investors… there has been a common intellectual patriarch, Ben Graham, but the children who left the house of this intellectual patriarch have called their “flips” in very different ways. They have gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply cannot be explained by the fact that they are all calling flips identically because a leader is signaling the calls for them to make. The patriarch has merely set forth the intellectual theory for making coin-calling decisions, but each student has decided on his own manner of applying the theory.
Academics Now Beginning to Debunk EMT
Reflecting the irony of Keyne’s observation that “practical men… are usually the slaves of some defunct economist“, there’s actually plenty of evidence debunking the EMT circulating now even amongst academic circles…[such as]:
- Robert Shiller showed back in 1981 that stock price volatility is far too high to be attributed to new information about future real dividends
- Research by Abarbanell and Bernard at Michigan University has shown that companies that surprise with higher than expected profits do not instantly get repriced. 25 to 30% of the repricing happens up to six months after the initial news.
- Even the father of efficient market theory, Eugene Fama, has cast doubt on its validity by showing that small cap stocks and low price to book stocks outperform the efficient market model
- Josef Lakonishok, Joseph Piotroksi and David Dreman in many different studies have shown that value stocks based on low price to book, low price to earnings and other metrics significantly outperform glamour stocks.
- As just one of several identified momentum effects, research by George and Hwang found that stocks near their 52-week highs tend to be systematically undervalued (investors use this level as an “anchor”, so they tend to be reluctant to buy a stock as it nears this point regardless of new positive information).
Why the EMH Became So Popular
Again, quoting Buffett, in his 1988 letter:
Amazingly, [EMH] was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.
The reason that EMH theory has caught on despite its clearly absurd underlying assumptions is that:
- it explains away…the persistent failure for the average fund manager to beat the market.
- [it reveals the extent of] incompetence of most fund managers
- [it bares]… the institutional imperative (aka. herd) behaviour of almost all fund managers.
- the vast size of many funds,
- the uncertainty of the timing of investment inflows and outflows,
- the fees/commission they charge and
- other factors discussed here.
We would argue that if you:
- don’t overtrade,
- have the discipline to hunt where others don’t look,
- invest time and money in good tools,
- and have a self-critical learning process that allows you to overcome your natural behavioural biases,
then the market can be beaten. Of course, that’s certainly not the same thing as saying it’s straightforward…
Dividends aren’t just for Warren Buffett and retirees. Dividends have the power to support your goals of becoming independently wealthy. Here are 3 reasons why. Words: 586
The traditional view of portfolio management is that three asset classes, stocks, bonds and cash, are sufficient to achieve diversification. This view is, quite simply, wrong because over the past 10 years gold, silver and platinum have singularly outperformed virtually all major widely accepted investment indexes. Precious metals should be considered an independent asset class and an allocation to precious metals, as the most uncorrelated asset group, is essential for proper portfolio diversification. [Let me explain.] Words: 2137
History has shown that investors who stick to disciplined, fundamental-focused strategies give themselves a good chance of beating the market over the long haul and James O’Shaughnessy has compiled data that stretches back to before the Great Depression…back-tested numerous strategies, and has come to some very intriguing conclusions. [Let me share some of them with you.] Words: 1325
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