investing

How The Popularity Of Efficient Market Hypothesis Benefits Value Investors

September 19th, 2013

Stay up to date

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Money on the ground: As the blog post will explain, believing in EMH means there's never any free money lying on the ground. CC image courtesy of Greg Dunlop

The 'Efficient Market Hypothesis' (EMH) is like a religion. Believing in it has a dramatic influence on the way you actually invest. Plenty of financial advisors believe in EMH, which makes this subject very relevant for us. Inthis series, we discuss what EMH is, why it's wrong and why that matters.

Inpart 5, we discussed the third and final reason why EMH is wrong: namely, that people chase short term returns, and often disregard the long term completely.

In this last and final instalment, I want to discuss what the rising popularity of EMH means for us.

How Efficient Is The Market Today?

There's no question about it. EMH is becoming more popular among ordinary investors. This means that more and more people are taking a completely passive approach to investing. The Canadian Couch Potato, for instance, takes this approach.

In today's environment, this is a good approach, though I'd argue it's not the best. It's a good approach because despite all the reasons that make the markets inefficient, the markets are still fairly efficient.

Let me qualify what I mean by 'fairly efficient'.

What I'm about to say is not a scientific analysis at all. It's more my personal observation, so take it with a grain of salt if you will. In my experience, you'll often see stocks that are undervalued by 30% or in rare cases, even 60%. But barring an unusual event like during the 2008 financial crisis, you won't see stocks that are undervalued by much more than that. In other words, you won't see stocks trading at 10% of its true value.

That means there's only so much room for even value investors to outperform. If you take fees into account, it's very difficult (not impossible, though) to consistently outperform the market. This is part of the reason why you see so few funds outperform over long periods of time. This is why the passive investing strategy makes sense, although like I said, you can still do much better.

A World With No Stock Pickers

There is an old joke about an economist who is a die hard fan of EMH. An economist and his friend are walking down the street when the friend sees a ten dollar bill on the sidewalk.

"Look!" he says, "its a ten dollar bill".

"Nonsense," says the economist. "If that was a ten dollar bill, someone would have picked it up by now."

Passive investors are like the economist who doesn't pick up the bill. They don't search out investment opportunties that could give them above average returns, instead letting others to do the 'picking up'. In fairness, it takes a lot of work 'pick up the bills'.

So imagine a world where every investor uses the passive strategy. What would that world look like?

Everytime someone buys into the stock market, that person will buy every stock in the market. That leads every stock to rise. Conversely, when someone sells, it leads every stock to fall.

There would be no differentation between stocks.

Earnings won't matter - because no one invests according to those. Dividends won't matter. Heck, even bankruptcy would not matter in the short run. If no one invests in individual opportunities, no one would sell just that one bankrupt stock.

This would be like a world full of economists like the one in the joke. We would see a world full of $10 bills on sidewalks, because no one's bothering to pick them up.

Passive Investing Helps Value Investors?

Of course, I'm not suggesting at all that this extreme situation will happen. Not everybody will invest passively. I brought up the hypothetical scenario because one thing is true:

More passive investors mean more opportunity for value investors.

As more people leave $10 bills for someone else to pick up, there will be more opportunities for value investors to pick up those neglected bills. Bringing the analogy back to the real world, more passive investors mean more inefficiencies in the markets, and that means more opportunities for discerning investors to make outsized returns.

Why Does All This Matter?

We're not suggesting that you should also go out and pick individual stocks. As we've explained, it takes a lot of knowledge and experience to do that right.

Instead, it matters because it affects how we choose our model portfolios. If we believed in EMH, we would come up with a portfolio that looks like the Canadian Couch Potato's. We would never change the portfolios, except to substitute higher cost ETFs with lower cost ETFs.

Instead, when we look at the markets, we see underpriced assets and overpriced assets. For example, I told our readers to dump longer term bonds, as they are likely overvalued. So far, it looks like I've made the right call.

Assets and stocks come in and out of vogue. Therefore, our portfolios will change accordingly as we favour undervalued assets, and shun overvalued ones. If you invest according to our portfolios, I think you'll reap the rewards of taking the value investing approach.

Epilogue: What The Experts Are Saying Today

EMH believers have long pointed to the many academic papers in support of EMH. I have news for these people:

The academics are starting to abandon EMH.

If you don't believe me, take a look at this interview of Daniel Kahneman, winner of the 2002 Nobel prize in economics. He won that prize for prospect theory, of which he had this to say.

prospect theory was really saying that people cannot be quite as rational as they have been described

He also goes on to say how economists are starting to abandon the notion that people make completely rational choices. As we've explained in this series, rational behaviour is the foundation upon which EMH stands. Take away rational behaviour, and you no longer have efficient markets.

Finally, I'll leave you with this video on Efficient Market Hypothesis by one of the most successful, and I must say infamous investors of our time.

Enjoy!

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.