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:
- Investors can trade stocks freely in any size, with no transaction costs;
- Everyone has access to the same information;
- Investors always behave rationally;
- 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 shared investor rationality is a seriously flawed and misleading one.
Secondly, EMH makes predictions that do not accord with the reality. Both the Tech Bubble and the Credit Bubble/Crunch show that that the market is subject to fads, whims and periods of irrational exuberance (and despair) which can not be explained away as rational. Furthermore, contrary to the predictions of EMH, there have been plenty of individuals who have managed to outperform the market consistently over the decades.
Many of these investors, such as Buffett or Benjamin Graham, have followed the value discipline, aiming to buy stocks for less than their intrinsic value, stubbornly refusing to get caught up in fashions and market whims, and sticking almost puritanically to their creed. Others, such as George Soros or Bill O'Neill, have been nimbler, believing the market acts in predictable cyclical fashion from under to over exuberance, testing investment theses by pyramid-ing their trades and swinging for the fences when entirely confident in the outcome. And it's not only these professionals, recent publications have shown plenty of small private investors that have been consistently beating the market year in year out.
Of course, it can be argued that these track records are merely the product of chance, that those beating the market are statistical “outliers” reflecting the sheer number of investors playing the market. However, Warren Buffett has countered this argument in a brilliant 1984 lecture entitled "The Superinvestors of Graham & Doddsville."
A Nation of Coin-Flippers
Buffett used the analogy of a national coin-flipping contest to explain the point. Imagine that tomorrow, 225 million Americans (or even orangutans) wakes up and are asked to put a dollar on a coin flip. Each day the losers drop out of the competition. And the stakes build as all previous winnings are put on the line. After 10 flips on 10 mornings, the 220,000 players left in the competition would have won over $10,000. In another 10 days, the 225 left in the game would have turned their initial $1 stake into over $1 million.
It is true that, in this scenario, the group of coin-flippers will likely think themselves investment geniuses, whereas, in fact, they are the product of chance. However, Buffett pointed out that there is some critical differences between this scenario of 215 lucky coin-flippers and the reality we face, namely the existence of shared characteristics of many of those successful money managers that cannot simply be explained away by chance. He explains:
If (a) you had taken 225 million orangutans; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he's feeding them, whether they had special exercises, what books they read, and who knows what else. That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors.
A Shared Intellectual Heritage
In this case, a wholly disproportionate number of the examples he has identified of market-beating performers all share a common intellectual heritage, namely they are value investors inspired by Benjamin Graham, who search for discrepancies between the value of a business and the price of small pieces of that business in the market.
In this group of successful investors... there has been a common intellectual patriarch, Ben Graham. But the children who left the house of this intellectual patriarch have called their "flips" in very different ways. They have gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply cannot be explained by the fact that they are all calling flips identically because a leader is signaling the calls for them to make. The patriarch has merely set forth the intellectual theory for making coin-calling decisions, but each student has decided on his own manner of applying the theory.
Even the Academics are beginning to twig
Reflecting the irony of Keyne’s observation that "practical men... are usually the slaves of some defunct economist", there’s actually plenty of evidence debunking the Efficient Market Theory circulating now even amongst academic circles. Just some of the more interesting papers include:
- Robert Shiller showed back in 1981 that stock price volatility is far too high to be attributed to new information about future real dividends
- Research by Abarbanell and Bernard at Michigan University has shown that companies that surprise with higher than expected profits do not instantly get repriced. 25 to 30% of the repricing happens up to six months after the initial news.
- Even the father of efficient market theory, Eugene Fama, has cast doubt on its validity by showing that small cap stocks and low price to book stocks outperform the efficient market model
- Josef Lakonishok, Joseph Piotroksi and David Dreman in many different studies have shown that value stocks based on low price to book, low price to earnings and other metrics significantly outperform glamour stocks.
- As just one of several identified momentum effects, research by George and Hwang found that stocks near their 52-week highs tend to be systematically undervalued (investors use this level as an “anchor”, so they tend to be reluctant to buy a stock as it nears this point regardless of new positive information).
Why EMH caught on like wildfire
Again, quoting Buffett, in his 1988 letter:
Amazingly, [EMH] was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market wasfrequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.
The reason that EMH theory has caught on despite its clearly absurd underlying assumptions is that it explains away something rather awkward - the persistent failure for the average fund manager to beat the market. But there is also another explanation for this woeful track record by fund managers, namely incompetence, coupled with the institutional imperative aka. herd behaviour. The vast size of many funds, the uncertainty of the timing of investment inflows and outflows, the fees/commission they charge and other factors discussed here also mean that institutional managers can be at a huge disadvantage to a motivated share-owner with less capital.
Instead, we would argue that, if you don't overtrade, have the discipline to hunt where others don't look, invest time and money in good tools, and have a self-critical learning process that allows you to overcome your natural behavioural biases, then the market can be beaten. Of course, that's certainly not the same thing as saying it's straightforward. Our goal however is to help you discover (some of) the inefficiencies in the market more easily by providing you with superior quantitative tools and first class data. We'll leave you with another inspiring quote from Warren Buffett in Business Week10:
If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.
- The Superinvestors of Graham and Doddsville
- Montier: Six Impossible Things before Breakfast
- Guy Thomas: Free Capital
- Matthew Schifrin: The Warren Buffets Next Door
- Werner F. M. De Bondt and Richard Thaler, "Does the stock market overreact?"
- Shiller, Robert, "Do Stock Prices Move Too Much to be Justied by Subsequent Changes in Dividends?", The American Economic Review
- Kurz, Mordecai, "Rational beliefs and Endogenous Uncertainty"
- Bernard, Abarbanell (1992), Tests of Analysts' Overreaction/Underreaction to Earnings Information as an Explanation for Anomalous Stock Price Behavior
- Fama, Eugene F.; French, Kenneth R. (1993), "Common Risk Factors in the Returns on Stocks and Bonds", Journal of Financial Economics 33 (1): 3–56
- Dreman (2005), Overreaction, Underreaction, and the Low-P/E Effect, Financial Analysts Journal
- George and Hwang, "52 Week High and Momentum Investing"
- Warren Buffett (5th July 1999), Homespun Wisdom from the Oracle of Omaha