The Efficient Market Hypothesis (EMH for short) is a theory developed and popularized by economist Eugene Fama in the mid-1960s to 1970s.
It states that the stock market is semi-strong form efficient where all past and presently available information about a particular stock or the economy has already been priced into those aforementioned stocks and/or the stock market as a whole. EMH also states that any arbitrage opportunities would be quickly picked up by “arbitrageurs” and average investors like us would not have been able to profit from them.
This means that individual stock-picking is futile in its efforts, and investors should just invest in the market, since the market is well diversified with its myriad of stocks, giving us purely systematic (market-wide) risk without the unsystematic (individual) risk that comes with individual stocks.
I’m reminded by a famous joke that went around that if an EMH investor sees a $50 bill on the ground, he will not pick it up as he believes markets are efficient and arbitrageurs would already have come in to pick it up.
The Traditional Finance Curriculum Doesn’t Explain Buffett
Finance students and graduates (including myself) have been drilled long and hard about the concept of EMH that we do not question or critique the theory. Over the years, more complex and sophisticated models have been built on the very foundations of EMH that would make Einstein proud. Models such as the Fama-French 3 Factor Model and various other Multi-Factor Models. I won’t go much into these models in this post – maybe in the future.
But I’ve always wondered… People like Warren Buffett, Joel Greenblatt, Peter Lynch…even Singapore’s very own Jim Rogers. How did they manage to make money off stock picking??
Is it a fluke?
Do they possess some “insider secret” or high-tech gizmo that can accurately predict which stocks would do well?
That started my journey 6 years ago in finding the answer – and I believe I have found it.
To identify the fallacy, we look at the assumptions of EMH.
One of which, is the assumption that all investors are rational decision-makers who possess perfect information in the stock market.
In theory, it seems logical that investors who put their money in the stock market would act rationally and are “somewhat” intelligent human beings. However, reality paints us a different picture.
We hear of stories of our aunts and uncles buying a stock because they got a hot stock tip off their friends or “a neighbor who works in finance”. This is a perfect example of irrational behavior in the stock markets.
You might be thinking that these groups of people are the minority. Surely the working professionals who invest are more rational… Let’s take a look.
During uncertain times, we hear in the news of people selling large amounts of their stock because of “an impending recession predicted by economists”. We could either say they are “perfectly rational” because they have taken in the news of the market and factored it in their decisions, or, we could say they aren’t rational because maybe the stocks they are holding are still increasing profits year-on-year and it makes no sense to sell. Seems pretty iffy to me. In my opinion, those investors are highly logical – they have taken the necessary decision to protect themselves after receiving such bad economic news. However, they are NOT rational. They put the burden of knowledge on the economist rather than the actual worth and financial standing of their own asset.
Another example – investors buying into stocks after reading a stock broker research report, without knowing that those broker companies might have received a fee for promoting those companies’ shares. Again, investors here are logical rather than rational – they put the burden of knowledge on the research report, rather than actually assessing the true value of their investment.
As you can see, already one of the assumptions of EMH has fallen through. And I have barely even scratched the surface yet. (I might cover this topic more in future posts!)
So… What Does This Mean?
It means that EMH doesn’t hold true all of the time. And, that there are opportunities for stock-pickers to profit and reap above-average returns relative to market.
Now, don’t get me wrong. I am NOT blasting the concept of EMH.
In fact, I acknowledge that EMH is true. However, *only* in the short term.
The accuracy of using EMH in the short-term will become higher (as seen from higher R-squared) as more algorithms, bots and robo-traders evolve and become the norm in the stock markets.
After all, these algos and automatic traders trade based on specific rules and not on emotions (which make them perfectly “rational”) and can factor in all potential available news in the markets.
However, I reckon it will still be a long way till markets become efficient in the long-term. This is where stock-picking opportunities can be created…if one just looks out further into their investing horizon.
Not surprisingly, Buffett, Lynch and all the other successful stock pickers all take a long-term view of the stock markets. And we as average retail investors can do it too.
False Sense of Security in Financial Modelling
Having taken Statistics in University, I deeply recall what my professor said about the use of models.
All models are wrong. But some of them are useful.B
Many of my finance peers fall in love with their models… be it Discounted Cash Flow (DCF), P/E (Price to Earnings), to the more complex Black-Scholes or Multi-Factor Models.
There is a certain sense of security having numbers to back up your investment thesis. But as I learned in statistics, all models are limited by constraints and assumptions – and even the best models are infallible to error and subjectivity.
One wrong assumption and it can take your investment returns way off course.
Moreover, market conditions change. How quickly your model is able to adapt to real-life market conditions will determine the returns you make. And so far, no model is dynamic enough to do so.
The Present Reality… And What Investors Can Do About It
So, with models being so complex and unpredictable, it is natural for many investors to fall back on what feels certain and predictable… be it believing in the EMH and buying index funds that track the market, or handing their money to a professional fund manager who seems to have an edge or expertise or the technology to maximize their returns.
But, from the above, we have seen that we have a very possible chance to control our investment destinies, and potentially achieve above-market returns.
And we can only do that by looking further out in our time horizons and playing the long-term investing game.