Ed Rempel continues his post about the Efficient Market Hypothesis.  This is Part 2 of 3.  If you missed Part 1, you can find it here

“I never blame myself when I'm not hitting. I just blame the bat, and if it keeps up, I change bats. After all, if I know it isn't my fault that I'm not hitting, how can I get mad at myself?” – Yogi Berra

Let’s take a closer look at the Efficient Market Theory (EMH). Are the markets efficient?

Many amateur and even professional investors dismiss it quickly, but it is clear there is evidence that the stock markets are relatively efficient. As mentioned in part 1, professional and amateur investors usually make considerable less than the markets.

When there is a takeover offer for a company, the price of that company’s shares almost immediately reflect the takeover price (less an amount because of the time until the takeover happens and less the degree of doubt as to whether the takeover will happen). This price adjustment shows market efficiency.

On the other hand, there is also clear evidence that EMH is not totally true. Index enthusiasts argue that all information is available to all investors and that they have rationally built it into the current share price. Therefore, the extreme belief would mean that throwing a dart at the stock page will be equally effective to all investment strategies. Their argument for owning the index is that you own “all of the market” (which is not really true), but their real belief is that any stock would be expected to have the same returns as the index (taking into account the risk level).

If you meet an EMH fanatic, just suggest that they throw a handful of darts at the stock pages instead of buying an index, and you will find they don’t really fully believe in the EMH after all.

The best arguments against the EMH come from the field of behavioural finance. EMH cannot explain market manias. It believes that all investors are always rational, but there have been many examples in history of “irrational exuberance” or irrational pessimism.

For example, the crash of 1987 saw the markets drop by more than 20% in a few days with little news. Seeing the large drops, investors dumped their stocks in panic selling. If you believe an investment is fairly valued, then how can you argue that panic selling as it falls is rational behaviour?

Here in Brampton, we saw our local company Nortel fall from $123.50/share to $.69/share in just over 2 years. EMH would argue that both prices were accurate based on known information. How can that possibly be? In hindsight, it is clear that it was never worth anywhere close to $123.50. This was part of the “tech bubble” with investors having piled into Nortel for a few years only because it was going up as it continued to rise and outperform almost all other investments. And $.69/share was equally ridiculous, with investors finally capitulating and dumping Nortel in mass.

Behavioural finance shows that many cognitive and emotional biases often result in prices selling for much higher or lower than they are really worth. As humans, our minds search for patterns and we see all kinds of patterns that don’t actually exist (clustering bias). We tend to be over-confident, anchor on past numbers, interpret data based on our preconceived views, feel safer following the herd, see things differently in hind-sight and fall prey to many other cognitive biases. (It is worth reading about behavioural finance, because then you will find listening to your investing buddies quite funny! People hate it when you name their investing cognitive bias!)

Humans also tend to often make decisions for emotional reasons. How often have you heard someone say they bought an investment because a “gut feeling” or “it feels right”? Is this rational behaviour? Irrational exuberance and panic selling are clearly emotional reactions and not rational behaviour, as EMH would argue.

The other big argument against EMH is the investors that beat the indexes by wide margins over long periods of time. EMH does claim, however, that by luck and with a normal distribution, a few investors would beat the markets by wide margins.

It is hard to put much faith in claims of spectacular returns by some amateur investors. They can usually not be independently verified, and studies show most amateur investors vastly miscalculate their own returns (if they calculate them at all). In addition, it is very difficult to find evidence that it was not just luck.

However, there are quite a few examples of professional fund managers beating the indexes by wide margins over long periods of time. Investors such as Warren Buffett, George Soros, Peter Lynch and Bill Miller have beaten the markets by such wide margins over long periods of time that the odds of it being luck are astronomical. These returns are verifiable public information.

There are also quite a few exceptional long term value investors. Value stocks and growth stocks tend to have similar long term returns, with each having their periods in favour. We recently had growth trounce value from 1995-99 so that all value style investments seemed boring and everyone wanted tech and all the high growth sectors. From 2000-2006, value has totally dominated so much that growth investing seems ridiculous and everyone wants resources, cyclicals, financials and dividend stocks. Now in 2007, it appears that growth is starting to take over again.

Value and growth have their cycles and similar long term returns. However, when you look at the long term exceptional investors, they are almost all value investors. For example, Rick Guerin managed the Pacific Partners fund from 1965 to 1983 (19 years) and averaged 32.9%/year while the S&P500 index made only 7.8%. He beat the index by more than 25%/year! Then there were Walter Schloss, Tweedy Browne, Charles Munger, Bill Ruane and quite a few more recent fund managers.

The unique point here is that all these managers are value style. The other 2 main investing styles, growth and momentum, rarely have a manager with long term large index-beating returns. This fact would seem to point to a systematic market inefficiency. The EMH cannot explain it.

In part 3, I’ll discuss my own humble opinions about EMH.


  1. FourPillars on November 13, 2007 at 1:24 pm

    Interesting post. I don’t disagree with your main point that the market is somewhat efficient however I disagree with your point that the odds of certain investors beating the market for many years in a row are astronomical. According to the “coin flip” analogy, if enough fund managers are involved in the survey, some of them will have incredible records by chance.

    As to the investors you mentioned, while I do think they are all good fund managers, I’m not sure if they all support your argument.

    Buffett & Soros – yes, they definitely support the idea that a good fund manager can beat the market.

    Lynch – great manager but he struggled when his fund got larger.

    Miller – had a great run for 15 years but what happened to those investors who bought in two years ago? He’s done terrible since then. In 2006 he got 5.85% vs 15.79% S&P, in 2007 he’s at 2.91% vs 9.13% S&P. I think it’s perfectly ok for a long term manager to have down years but to assume they can beat the index every year is unrealistic.

    Bottom line is that even if some managers can outperform the market for long periods of time – what are the odds of being able to identify those managers in advance? I’m going to say ZERO!


  2. Gates VP on November 13, 2007 at 6:25 pm

    I personally would like to go with the markets are reasonably efficient. There simply seem to be too many irrational or poorly educated investors for there not to be some “margin of error”.

    Of course, it’s easy to re-enforce the “buy & hold indexes” strategy by citing transaction costs and taxes. And they’re right, you can beat the crowd and the beat the market but still lose to “the rake”. But then you haven’t really proven that the markets are efficient as much as you’ve proven that the current overhead on the markets eliminates the current “margin of error”.

    There’s money to be made out there, there definitely is, but it’s not an easy game, and you have a very limited number of “hands”.

  3. nobleea on November 13, 2007 at 9:26 pm

    I like the comment that amateur investors often exaggerate their returns. I don’t think they do, but fail to look at their entire portfolio. Sure, “I had a triple on this stock” is great, but it is usually accompanied by a couple dogs, which in turn averages it out to a less spectacular return.

    I do think the markets are semi-efficient. I believe that the degree of efficiency increases with the size of the company. The larger the company, the more likely its price will reflect all the information publicly available on the company.

  4. Ed Rempel on November 14, 2007 at 2:22 am

    Hi Mike,

    Interesting. Of the managers you mentioned, Buffett and Miller are still active. Do you think they will beat the market from now on?


  5. Ed Rempel on November 14, 2007 at 2:42 am

    Hi Noblea,

    I think most investors don’t even know how to calculate the rate of return.

    One study I saw claimed that the average individual investor actually made 20% lower return than they believed – as in the average individual investor claimed to be making 15% when they are actually losing 5%.

    Let’s say you start with $10,000 in an investment on January 1 and invest $3,000 on March 17, $5,000 on May 3 & $4,000 on September 27, received $400 in dividends, and borrow $12,000 on margin on August 18 paying $300 in interest. You invest $5,000 of the $12,000. Then you sell $4,000 on November 18. At the end of the year, you have $26,000 in the investment. For simplicity, assume only one investment was purchased. What was the rate of return?

    My guess is only about 10% of investors would know how to calculate this. And of these 10%, how many would bother?

    I believe the truth is that the rate of return almost all individual investors claim they made is a “gut feel” and they have not calculated or even estimated it. Or perhaps they claim the rate of return from the internet or the paper on their single best investment.


  6. Telly on November 14, 2007 at 11:01 am


    You make a good point in your last comment. However, even an index / ETF investor would be required to do similar calculations to determine their rate of return. So regardless of what you purchase, WHEN you pruchase is also a factor. Index investors can also be irrational if they deviate from their planned asset allocation or regular contributions. Even Bernstein believes you can boost your returns somewhat by tweaking when you buy certain ETFs / index funds. This, to me, indicates that markets can not be 100% efficient.

  7. FourPillars on November 14, 2007 at 1:09 pm

    Tough question Ed. The EMH part of me wants to say that we can’t predict whether they will beat the market or not. Logically I can’t ignore their success so I guess my answer is that although I can’t be sure that they will beat the market in the future, I would have more confidence in them than any other managers available.

  8. FourPillars on November 14, 2007 at 1:13 pm

    Ed & Telly – I’m amazed that more investors don’t keep track of their performance. Even most of the Cdn bloggers I’ve talked to don’t keep track, although in their defence most of them make contributions that outweigh their investment returns which makes measurement not as useful.

    Regardless I think everyone should measure their performance – at least to approximate it (which is what I do).

  9. Telly on November 14, 2007 at 4:55 pm

    Sounds like a good post Mike. I have to be honest in that I’m in the camp that doesn’t. :( Yes, our contributions outweigh our gains right now and we’re about 90% indexed but it still makes sense to do so.

  10. FrugalTrader on November 14, 2007 at 5:42 pm

    Telly, do you index with ETF’s or mutual funds?

  11. Nabloid on November 15, 2007 at 5:28 am

    If the markets were efficient than it wouldn’t decide that a company was worth $1 million one day and the very next day $800,000… only to decide the company was worth $1.2 million three days later… all with no company news coming out… The big players are doing such volume that smaller stocks get wild swings that have very little to do with their intrinsic value. Just becaus some large hedge fund goes bankrupt on some leveraged bet and then is forced to liquidate a bunch of stock all on one day… well the prices plunge, but a few weeks later they all recover… and all the while it had nothing to do with those company values.

    Though if you think about it, a stock is worth what someone will pay… and in that sense I guess the market is efficient on each particular day… But IMO, the market has never been 100% efficient.

  12. […] November FrugalTrader05:00 amAdd comment This is the final installment of Ed Rempel's "Is the Market Efficient?" series.  In case you missed the other articles, here you find Part 1 and Part 2.  […]

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