(In)efficient: Can the market be beaten?

Thursday, Feb 02 2012 by
Inefficient Can the market be beaten

For much of the last 25 years, most of the investment management world has promoted the idea that individual investors can't beat the market. To beat the market, stock pickers of course have to discover mispricings in stocks, but the Nobel-acclaimed Efficient Market Hypothesis (EMH) claims that the market is a ruthless mechanism acting instantly to arbitrage away any such opportunities, claiming that the current price of a stock is always the most accurate estimate of its value (known as "informational efficiency"). If this is true, what hope can there be for motivated stock pickers, no matter how much they sweat and toil, vs. low-cost index funds that simply mechanically track the market? As it turns out, there's plenty!

The (absurd) rise of the Efficient Market Hypothesis

First proposed in University of Chicago professor Eugene Fama’s 1970 paper Efficient Capital Markets: A Review of Theory and Empirical Work, 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.

However, despite still being widely taught in business schools, it is increasingly clear that the efficient market hypothesis is "one of the most remarkable errors in the history of economic thought" (Shiller). As Warren Buffett famously quipped:

 "I'd be a bum on the street with a tin cup if the market was always efficient". 

Similarly, ex-Fidelity fund manager and investment legend Peter Lynch said in a 1995 interview with Fortune magazine:

“Efficient markets? That’s a bunch of junk, crazy stuff”. 

So what's so bogus about EMH? 

Firstly, EMH is based on a set of absurd assumptions about the behaviour of market participants that goes something like this:

  1. Investors can trade stocks freely in any size, with no transaction costs;
  2. Everyone has access to the same information;
  3. Investors always behave rationally;
  4. 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…

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