According to the Efficient Market Hypothesis financial markets are absolutely efficient. At any given point the price of a security reflects all available information relating to that security at that moment.
There are three forms of the EMH: Weak, Semi-Strong, and Strong. The Weak Form suggests that a security’s price reflects all past publicly available information. The Semi-Strong Form takes it a step further, suggesting that new information is reflected so quickly in the trading price that no person can benefit from new information on a large scale. Lastly, the Strong Form argues that current security prices reflect all information, public and private. In essence “inside information” is reflected in current security prices and offers very little advantage to those who come across it. There are very few supporters and substantial evidence contradicting the Strong Form of the EMH.
If we accept that markets are absolutely efficient, logic dictates that no investor can consistently beat the market without taking a correspondingly higher degree of risk. The implications of this conclusion for a technical analyst are substantial. If historical price trends have no correlation with future price movements, technical analysis is useless. Fundamental analysts are dealt a considerable blow by the EMH as well. Assuming current market prices reflect all available information, pouring through companies’ financial statements will not result in outperformance on a consistent basis.
I am not offering the Efficient Market Hypothesis as an excuse to throw money at an index mutual fund every quarter and let the “efficiency” of the market decide the future course your investment returns. Nor am I suggesting that technical and/or fundamental analysis will not lead to over-performance. But facts are facts; history shows that beating the market year-after-year is a skill that eludes even the most experienced money managers on The Street.
I believe that establishing an investment portfolio with a risk-adjusted asset allocation gives investors the ability to choose the best securities available within the categories that make up their asset allocation. As exchange-traded funds grow daily in popularity, the question of whether a large cap U.S. market allocation should be directed toward (NYSEARCA:IVV), (NYSEARCA:PWC), or (NYSEARCA:RSP) will be left to investors. While RSP—using an equal-weight strategy—may outperform the others one quarter, the relative underperformance of the others pales in comparison to the losses sustained by the stock-picking money manager that bets on the wrong horse.Regardless of whether you believe that markets are absolutely efficient—the jury is and will remain out—I’d argue that beating the market is, at best, something of an audacious goal. If we “over” perform on the downside, slight under-performance on the upside will not cost us quite so dearly. Home runs are fun to watch, and every now and then you might buy Apple (NASDAQ:AAPL) at 100 and watch it nearly triple in value. But everybody loves a winner, and the best game plan puts the best players on the field, and lets them do what they are paid to do!
Disclosure: No Positions