Efficient Market Hypothesis

“Ships will sail around the world but the Flat Earth Society will flourish.  There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.” – Warren Buffet

 

Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.

 

The Efficient Market Hypothesis is an investment theory that stock prices trade at their fair value as they reflect all relevant information and adjust quickly and accurately to new information.  Stock prices not only reflect past information but also what the market expects for a stock to take place in the future.  It is therefore impossible to “beat the market” because it is impossible for investors to either purchase undervalued stocks or sell stocks at inflated prices.  It should therefore be impossible to outperform the market by way of skilled stock selection or market timing, and that the only way you can achieve higher returns is by purchasing riskier investments or by luck as events for a stock do better (or worse) than expected.

If one believes the market is efficient, then one should not spend any time doing stock research.  Your exposure to stocks should then be through buying stocks as cheap possible (low transaction costs and low holding costs).  So you would be enticed to buy low cost market indexes and seek to manage your taxes.

As a significant number of people, including prominent academics, feel this theory is valid to some extent, it is the basis why indexing is as prominent as it is today.  With the performance of professional investment advisers showing few able to consistently outperform the market through time, this has added credibility to the theory.

The reality is that the theory is flawed as the assumptions underlying it are flawed.  Human beings are emotional and not all human beings are perfectly rational (if given certain financial information, would discern the information the same way and come to the same decision).  We are also biased, favouring some stocks or investments over others.

Richard Thaler, a behavioral economist, rightly stresses the confusion between the two different interpretations of the EMH: Some economists took the fact that prices were unpredictable to infer that prices were in fact “right” or at fair value.  Also, as early as 1984, Robert Shiller stated that prices can be unpredictable and still wrong, “the difference between the random walk fluctuations of correct asset prices and the unpredictable wanderings of a drunk are not discernable”.

The logic of few professional investment advisors consistently doing better than the market is also flawed.  Imagine if we remove the amateurs.  What remains is the market.  On average, the professional advisers should do what the market does less costs.  Alternatively, consider a card game.  The amount won should equal the amount lost less what the house takes.  But hidden in this average is the card shark.

Even if you believe in the Efficient Market Hypothesis, the notion of buying stock indexes is also flawed.  Stock indexes constructed based on market capitalization can lead to lower returns due to the largest market-cap companies dominating an index.  As such, as the index goes up, you end up buying more of the most expensive stocks taking on more stock risk.  Similarly, an index includes not only good businesses, but also bad businesses and businesses that are overpriced so one can benefit by avoiding these.  Lastly, the largest market-cap companies of the index are stocks that everyone knows about and what many people own so they tend to be well-researched and tend to have lower returns than the rest of the companies in the index.  So a portfolio containing less of the largest companies can do better.

What index investing does do is help reduce risk of poor performance through poor stock selection or poor risk management.  Index investing is terrific where one is investing a small amount of money, where one has a low level of investment knowledge or experience or where one has a low risk tolerance (if your portfolio drops with the market, you may be less likely to sell when down and instead recognize the market is on sale and emotionally be able to add to the index at that time).

Investing in individual stocks comes down to whether you have:

  • enough money to be able to diversify your investments at an affordable cost,
  • adequate investment knowledge to select good investments, and
  • the right behavioural (non-emotional) decision-making ability.

Lastly, if you can’t do it yourself, spend the time you need to do it yourself, or if you think it is helpful to have someone help you, then hire a professional investment advisor – just make sure you find right one: http://money.ca/you_and_your_money/2015/06/24/find-the-right-advisor/

 

Steve Nyvik

Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P. WHAT I DO: Steve builds, from blue-chip dividend paying stocks and bonds, a tax efficient 'pension' designed to meet your needs through time without taking unnecessary risk. Financial planning advice and service are included to make sure that if ‘life happens to you’, your goals aren’t derailed in the process. Phone: (604) 288-2083 (extension 2) Toll Free: 1 (855) 855-9267 (extension 2) Email: Steve@lycosasset.com