Today concludes our four-part series on the efficient market hypothesis. While the EMH helps us understand how markets work, in terms of investment strategy it really doesn't matter whether markets are efficient or not. The only thing that really matters is whether you can exploit inefficiencies persistently, after the expenses of the effort. That has proven to be extremely difficult - so difficult in fact that even the behavioralists, who poke holes in the EMH by identifying persistent mistakes that investors make, recommend acting as if the market were efficient.
Richard Thaler, one of the "fathers" of behavioral finance, in an interview with The Wall Street Journal in which he was discussing market inefficiencies, conceded that most of his retirement assets are held in index funds, the very industry that Fama's research helped to launch. And despite his research on market inefficiencies, he also conceded that "it is not easy to beat the market, and most people don't."1
Now listen to Daniel Kahneman, a Nobel Prize winner for his work in the field of behavioral finance. "Investors shouldn't delude themselves about beating the market. They're just not going to do it. It's just not going to happen."2 Kahneman also observed:
"What's really quite remarkable in the investment world is that people are playing a game which, in some sense, cannot be played. There are so many people out there in the market; the idea that any single individual without extra information or extra market power can beat the market is extraordinarily unlikely. Yet the market is full of people who think they can do it and full of other people who believe them. This is one of the great mysteries of finance: Why do people believe they can do the impossible? And why do other people believe them?"3
The bottom line is this: It's clear that markets aren't perfectly efficient. In fact, I'm not aware of anyone who claims they are. They fail at all three forms (weak, semi-strong, and strong) of the EMH. And it's equally clear that markets aren't always rational. However, the EMH does provide us with important insights into how competitive forces work in setting asset prices. And despite the fact that markets are clearly not perfectly efficient, the EMH also guides us to the strategy that's most likely to allow you to achieve your financial goals - building a globally diversified portfolio of funds that provide access to the asset classes and factors you decide are appropriate for your personal situation, and avoid actively managed funds. That's because the EMH, while failing all the other tests of efficiency, passes the most important one - the odds of risk-adjusted outperformance, after the expenses of the effort, are so low that it simply isn't prudent to try.
If markets are so inefficient, the results should show up in the performance of active managers. Yet they don't. William Bernstein, offered this analogy:
"The debate between active and passive management is like the debate between astrology and astronomy. Take the case of emerging markets: If you're going to have an edge somewhere as an active investor, it ought to be in emerging markets. Well, there is no edge in emerging markets; the passive funds, particularly the value and small-loaded products from Dimensional Fund Advisors, have done spectacularly well."
And we can add this: If the markets are so inefficient, how does the DFA International Small Value Fund end up with a first percentile 15-year ranking?
As a final note, consider the following. Warren Buffett has often criticized the EMH, noting that if the markets were efficient, people like himself and Charlie Munger shouldn't exist. Yet in his 1996 annual letter to Berkshire shareholders, Buffett offered this advice:
"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."
The EMH passes the only test that matters to investors - the market is efficient enough to prevent the vast majority of investors from being able to persistently exploit, after the expenses of the effort, any inefficiencies.
- "As Two Economists Debate Markets, The Tide Shifts," Jon E. Hilsenrath, The Wall Street Journal, 18 October 2004
- Daniel Kahneman, Nobel Prize Laureate in Economics, Orange County Register, January 2, 2002.
- Daniel Kahneman, professor of psychology and public affairs at Princeton University, Dow Jones Asset Management, (November-December 1998).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.