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Why I Do Not Believe In the Efficient Markets Hypothesis

"Martha Stewart should never have gotten into trouble for trading on insider information about the company headed by her friend Sam Waksal." If you believe in the so-called efficient markets hypothesis (EMH), or at least its "strong form," you would believe in that premise as well. That's because this form of the hypothesis posits that there is no advantage to be gained from non public information, because such information would be IMMEDIATELY made public as soon as it became available, perhaps by bloggers like ourselves. In that case, there would be no such thing as insider t... and no need for an SEC to regulate it.

All right, most people do see the need for an SEC to protect investors against being "ripped off" by inside traders who know "too much." That's another way of saying that they believe markets aren't totally efficieint. But many of these same people believe that as long as trading is limited to "public" information (with restrictions on trading by people with "inside knowledgle," stock prices (and returns) follow a "random walk," meaning that one trader is as good as another. This is called the semi-strong form of the efficieint markets hypothesis. But many people who believe this are losers in the stock market. Moreover, they are at a loss to see how people like Warren Buffett can continually "beat the market."

It is the "weak" form of efficient markets that appears to hold up. Past stock price movements don't predict anything alone, and "chartists" or technical analysts may be useless, unless they also bring fundamental analysis to the table.

One group of people than can apparently beat the market is value investors, particularly those that follow the tenets for Ben Graham and David Dodd, like Warren Buffett, and hopefully, yours truly.  In an article "The Superinvestors of Graham and Doddsville," Mr. Buffett demonstra... a small subset of monkeys could "beat the market:," and therefore trivialize the problem--unless it happened that most of them came from say, the same zoo in Omaha. In fact, he pointed out that the most successful investors of his time came from an intellectual retr... and Doddsville."&nbsp... was too strong a relationship to be ignored.

Regarding the efficient markets hypothesis, Mr. Buffett said, "Observing correctly that it holds MOST of the time, academics [opined] that it held ALL of the time. The difference between the two propositions is as night and day."

On the other hand, some Nobel Prize winners got into deep trouble testing their emerging markets hypothesis at a place inaptly named Long Term Capital. In August 1998, their hedge fund suffered heavily from the turmoil in emerging markets debt. What's worse, when the markets came back in September, emerging markets issues rebounded EXCEPT for those known or believed to be held by Long Term Capital. Traders figured that those issues would soon be available at firesale prices when Long Term Capital collapsed, so why bail them out. The prize winners were "shocked, shocked, shocked" to find that Wall St. would trade in such a "defensive" (or predatory) pattern, instead of "moving with the market." So much for efficient markets, at least when one firm was THE market (in certain securities).