Thursday, 30 May 2013

I am no longer a believer in the Efficient Market Hypothesis

When I studied finance at university one of the first things that was taught to use was that markets were efficient and that there was no way to beat them.  This was proven out by studies and seemed to prove up the 'Efficient Market Hypothesis' (EMH), the idea that when relevant information hits the market it is immediately is priced into the market.

The upshot of that particular hypothesis for investors is that you cannot consistently outperform the market.  You can have 'lucky runs' but the market is constantly pricing in new information and if you have a different view the the market, it is because you do not have as much information as the market.
The EMH has constantly concerned me as an investor.  After all if you can't beat the market what is the point of researching stocks in order to achieve 'alpha'?
This has also affected my professional career.  Although, as I have said before, I find value investing the most appealing form of investment and the most 'rational', I have always wondered about this innate inability to know more than the market and to thus outperform the market in the long run.

However the market often trades on sentiment and fear which has no place in fundamental investing

Those of us who have been investing in the recent past have seen greed and fear at it's most rampant.  The GFC and fear of all things debt related and the more recent greed associated with any yield providing stocks have caused share prices and market valuations to skew wildly away from what value or fundamental investments would suggest.

If you can remain the neutral bystander and be the person who processes information logically and without getting caught up in the market hype, sure you should be able to outperform those who are constantly being swayed by the 'tone' of the market.  Sure your timing will not always be perfect, but if you can achieve even marginal alpha then this suggests that strong form and semi-strong form market efficiencies do not exist (note strong form efficiencies says that all information, both public and private is priced in the asset prices, while semi strong form says that all public information is priced into the share price and it is impossible to outperform this)

Markets will often move from seemingly useless information

If you invest in the stock market or even follow the share market you will notice that seemingly useless pieces of information can affect share valuations.  For example when there is disappointing jobs
data released in the US, you will notice that most US stocks will be affected negatively which will then flow on to other share markets around the world.

The idea that an Australian bank, catering only to Australian investors is worth 1 - 2 % less because there were fewer jobs created in the US than was expected, even though they have no US customers or exposures seems crazy to me.  I know you can play out the whole trade argument, but if you're telling me that this can be forecast into share price valuations with any kind of certainty then I'm going to tell you that you're nuts!

I'm sticking to pure value investing...and now I completely believe in it

I have finally let go of the last doubts associated with EMH.  I do not believe that it is true - the markets trade too much on information that is useless or over-react to information that is relevant for me to believe in EMH.

I truly believe that by looking at investments analytically and by not being swayed by the markets and market emotions that I can outperform the market over the long run using value investing.  Note that I still do not believe that technical investing has merit - I do not believe that charts and historical prices can tell you anything about future prices.

Do you believe in EMH or do you believe that you can outperform the market?  On what basis do you invest?

You May Also Be Interested In:
What does 'generating alpha' mean?
What is diversification and how does it work?
What is investment risk?
Investing in Index Funds: A cheap easy way to access the share market

No comments:

Post a Comment