Ed Rempel, a CFP and CMA, has written another guest post. This time, the subject is on the equity markets and their efficiency. It's a fairly long post, so get comfortable. This is Part 1 of a 3 part series.
“You can observe a lot just by watching.” – Yogi Berra
The Efficient Market Hypothesis (EMH) has been widely discussed by many market experts. Understanding it and having an opinion on it is very important for any investor. If you want to develop your own belief about how to invest effectively, having an informed opinion on EMH can be very helpful.
Those who believe in index investing or who market ETF’s are the biggest supporters of EMH, as are most market academics and many newspapers columnists. Most of the top investment managers have specific opinions on EMH and those that beat the indexes over time can almost always tell your why.
EMH has been subject to a lot of hype and marketing. Is the market efficient?
I won’t bore you with an in depth description. The basics, however, are that EMH maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally. In other words, there are millions of investors that all have access to all available information about any company and these investors make rational choices of which stocks to buy based on all this available information. Therefore, all stocks are always priced accurately.
When new information becomes available about any company, it is immediately available to all investors who quickly assimilate it with all other information and adjust the stock price accordingly. This means that all stocks are priced correctly all the time and future price movements result from new information that cannot be anticipated from existing known information. Therefore, future price movements are a “random walk”.
The main evidence to support EMH is that most investors do not beat the market. Many studies have shown this. The most popular is usually the Dalbar study that is updated every year. It is now a 20-year study and shows that over the last 20 years, the S&P500 has averaged 13%/year, the average mutual fund (professional investor) has averaged 11%, the average investor (amateur investor) has average 3.5% and the average market timer has averaged a loss of 3.5%. Most of the time, only 20-45% of mutual funds beat their index (depending on which time frame and which index). Clearly, the methods of most investors (professional or amateur) are worse than the market averages.
There are 3 levels of EMH based on the types of information that are fully accounted for in existing share prices:
Weak EMH: All historical market prices and financial data are known to all investors, so no investor can get better returns from analyzing them. This means that all technical analysis (charting) will not work except by luck. Fundamental analysis to figure out the true value of companies can still produce better returns, however.
Semi-strong EMH: All public information about all companies is known to all investors, who are rational and unbiased. This means that fundamental analysis of stocks also cannot produce better returns except by luck. However, insider information or on-site visits could still provide information to produce better returns.
Strong EMH: All public and insider information is known to al investors. Insider information leaks out and laws prevent insiders form using it, so even insider information cannot produce better returns except by luck. Therefore, no strategy or investment method can produce better returns except by luck. A monkey can then pick stocks as well as Warren Buffett.
The big question whenever we hear about any investment strategy or the returns of any investor is: How do you know it is not just luck? EMH claims that future returns from any strategy will fit into a “normal distribution” of possible returns. Whenever you look back, some strategy will have worked better than others, and those that believe in it will claim it was skill (hindsight bias). In fact, since the markets usually rise about 70% of the time, EMH claims that essentially all strategies should work about 70% of the time over the long run.
Market theorists and university professors, of course, tend to believe it, since it is intellectual and relatively simple.
Newspaper columnists often like EMH, usually because it is simple and because it is much more difficult to effectively recommend specific investments. If nobody can beat the market, then the only important factor in investments is the cost of trading or the MER of a fund, which is a very simple concept. Jonathan Chevreau has written hundreds of articles about how nobody can beat the market – so just buy ETF’s.
Professional investors, or course, generally disagree with EMH, since it means that none of them are any better than anyone else. Many dismiss it as ridiculous, but many others have very valid criticisms.
Many amateur investors don’t believe in EMH, usually because of a lack of understanding about it. Most people think they are smarter than average and better investors (and drivers) than average, while EMH claims that the only reason anyone gets better returns is dumb luck. Folklore about the amazing returns of some amateur investor and dreams of making big money fuel this. “If Joe’s brother-in-law can do it, then I so can I…”
Many amateur investors (if they know about EMH) often falsely believe that EMH means the current price of a stock reflects the future returns that stock will actually make. EMH does not claim that all future information is built into existing stock prices. It claims the likelihoods of all possible future outcomes are taken into account in current share prices. EMH also does not claim that investors act randomly – only that share prices move randomly since they result only from investors reacting to new information as it becomes available. This new information could be about the company, the market, the economy, political events or anything else that might affect the value of a company’s shares and cannot be anticipated.
In part 2, we’ll have arguments for both sides and my personal humble opinion. What do you think – are markets efficient? Is all information available to all investors? Do investors actually access this information and understand it before making investment decisions? Are investors rational? (By the way, if you really understand EMH, I doubt you will either dismiss it completely or believe it completely.)