The Efficient Markets Hypothesis: What You Learned in School Can Hurt You

Jan.16.09 | About: SPDR S&P (SPY)

If you’re like me, you’ve been a subject of indoctrination. Your professors taught you that markets are efficient and that all available information is already priced into stocks. Above-average investment performance is due to luck, not skill. Reading this article is a waste of time.

Since you are reading this article, I assume you are open to the argument that markets are not always efficient. Unfortunately, your residual regard for the Efficient Markets Hypothesis (EMH) may be impacting your ability to act contrary to the conventional wisdom. You may hesitate to invest in an obviously cheap stock because you think, “It must be cheap for a reason.” (I know this line of thinking because I’ve been susceptible to it.) While cheap stocks are indeed cheap for a reason (by definition), all reasons are not created equal. If a stock is cheap because its market cap is so small that no informed investor has discovered it, you may be looking at an excellent investment opportunity. If, on the other hand, a stock is cheap because it faces significant risk of bankruptcy, you may want to stay away.

I have developed a mind trick that allows me to make the EMH work for me, and I hope it can work for you too. Next time you encounter a security that appears cheap after thorough analysis, don’t simply say “it must be cheap for a reason” and move on. Instead, consider that if the efficient markets hypothesis is true, the stock must be efficiently priced, i.e., you would be buying it at a price that fairly reflects the risks involved. Regardless of how things turned out, your decision to buy the stock would not have been obviously stupid. So use the EMH to overcome your fear of the downside when all factors point to the likelihood of nice upside.

Economist Meir Statman argues that “finance scholars would do well to accept market efficiency in the beat-the-market sense but reject it in the rational prices sense.” Statman’s argument that markets are inefficient but cannot be beat strikes me as unsatisfactory. If we know that markets are inefficient, we should have a fairly good sense of why they are inefficient, providing long-term investors with a starting point for outperformance.

Say Goodbye to the EMH

Investment success requires a departure from the EMH, as adherence to the latter results in investment strategies focused on low-cost indexing. The following few points should help you put the EMH to rest.

First, respected economists such as Yale’s Robert Shiller have by now presented significant challenges to the EMH. This makes the hypothesis more controversial in academia than only a decade ago.

In addition, the experience of investors such as George Soros and Warren Buffett cannot be ignored. Soros and Buffett have beaten the averages so consistently and for so long that the probability of their successes having been due to luck is minuscule. I would understand skepticism if Soros and Buffett’s respective approaches were based on astrology, but their approaches make sense. The only surprise is that more investors have not emulated them (perhaps thanks to widespread EMH indoctrination).

Finally, consider whether the EMH makes sense in light of past stock market crashes triggered without any major news (Black Monday is an example). The only explanation that makes sense to me includes the existence of “herd mentality,” or investor behavior that is driven not only by fundamentals. A model of herd mentality may differ from the rational expectations model by assuming a positive correlation between the actions of market participants. If I sell, you may see a slight price decline, making you slightly more likely to sell as well. If we both sell, the next person may be slightly more likely to sell than you were, and so on. Had you bought instead of sold, our effects on the next person would have canceled out — this is the reversal mechanism that typically plays out in daily market action.

However, positive correlation would in rare instances produce a snowball effect, accelerating selling once a tipping point is reached. This type of model might explain Black Monday. To understand the eventual reversal of selling, we need to introduce one or more other variables that influence trading decisions. The most significant variable is fair value – at some point, investors will decide that stocks have become too cheap and will start buying. This variable is consistent with the rational expectations hypothesis of efficient markets (unfortunately, EMH ignores any correlation between the actions of market participants).

Another variable that can help restore market equilibrium after panic selling or euphoric buying might be what behavioral finance calls “anchoring.” If prices at yesterday’s market close are the anchor, imagine a spring hanging off that anchor – you can pull in either direction, but the more you pull the more resistance you experience. At some point, the force of the spring will counterbalance the force of your pull, and prices will stop moving in one direction.

Before we say good-bye to the EMH, it’s fair to point out a reason for not forgetting the EMH entirely. Investors suffer from a number of cognitive biases, one of which is overconfidence. Past success or interaction with a company’s executives can make us more confident about our estimate of underlying value than we should be. Remembering the EMH ever so slightly can help us guard against overconfidence, because we will be more inclined to consider the risks to our thesis on a particular stock.

Evolved View of the Stock Market

Former Columbia professor and the father of value investing Benjamin Graham once said, “Price is what you pay; value is what you get.” Many investors agree with this statement – though only outside the investment arena. Few of us would refuse to buy an item in a department store just because it is on sale, yet many do just that when it comes to the stock market. The fear associated with buying a depressed stock, obviously, is that the price decline signifies a fundamental problem. Yet even if the decline has been caused by a decline in intrinsic value, the question is whether the price has declined more than the value erosion warrants. Disciplined investors try to estimate the intrinsic value of companies within their circle of competence and buy them when the price drops far below estimated value.

Graham’s 1949 classic The Intelligent Investor describes something akin to a free option contract available to every investor: At any time, you can choose to buy or sell a share of a business in the market at the prevailing bid price. If you believe the price is sufficiently below or above intrinsic value, you may exercise your option to buy or sell (short) the stock. Writes Graham:

Imagine that you own a small share of a private company that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on your own research and company reports regarding their operations and their financial position.

Contrary to what is taught in most finance curricula, “Mr. Market,” at least in the short term, is not an infallible appraiser of businesses (a “weighing machine”) but rather the sum product of the opinions of a herd-like group of investors susceptible to subjective influences and cognitive biases (a “voting machine”).