Post Tagged with: "efficient market theory"

Efficient Market Theory and Indexing

April 14, 2008

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A good definition of efficient markets can be found in a paper by Eugene Fama titled Random Walks in Stock Market Prices:

An “efficient” market is defined as a market where there are large numbers of rational profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which as of now the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

While academics like Fama set store by EMT, on the other side of the fence are people like Warren Buffett whose tremendous long-term track record appears to contradict the theory. Buffett himself has weighed in on the validity of EMT noting that “observing correctly that the market was frequently efficient, [efficient market theorists] went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day”. In this battle of giants, which side would you pick?

At first glance, the debate seems to be of enormous importance to indexers. If EMT is true and stock prices reflect all publicly known information and are subsequently fairly valued, then it follows that it is futile to try to beat the market and indexing would be the only way to invest.

But what if EMT isn’t always true? We all know that people can be very foolish at times; so perhaps, smart investors can take advantage of other people’s foolishness. To paraphrase Buffett, maybe it’s possible to find flowers that are priced like weeds. However, there is a fly in the ointment (or a caterpillar in the salad, as P. G. Wodehouse would say): even if stock prices are occasionally (or even frequently) mispriced, can average investors (or indeed the average fund manager) readily take advantage of it? Here, the evidence is overwhelming that beating the index consistently is extraordinarily difficult because investors have to overcome what John Bogle calls the relentless logic of humble arithmetic – investors, on average, can only earn the returns that the market Gods provide less expenses. Thus even if EMT turned out to be invalid, a strategy of earning market returns while keeping expenses low is still a winning strategy.