I LOVE THE EFFICIENT MARKET HYPOTHESIS – AND YOU SHOULD TOO!

In my previous blog post I wrote about why the efficient market hypothesis is wrong. In this blog post I’m going to tell you why this common misperception is the best thing that ever happened to the individual investor whether he is brand new to investing or have years or experienced.

First however, let me answer a question I know a lot of investors rightfully seem to have. What do they teach at business schools after they tell you that the market is efficient? Is there really anything more to say if that is the case? Let me take you with me, down on memory lane when I was a young student that (wrongly) thought I was going to conquer the financial world after graduation.

Back in the days at the business school, after it was quickly established that no one could beat the market, I was introduced to a variety of new concepts about stock investing. This was great! I saw that everything in investing could be explained by equations. As a kid I always played games like backgammon and Yachty where math in the long run determines if you won or lost. I felt I was on the front row to learn how math could help me win another game – this time with much bigger rewards. You might question how you could win in a game where the outcome would be the same. I mean, if we all get the same returns in the stock market because it’s efficient – how can you win in the game?

Easy! You win in the game by getting the same return as everyone else, but with the lowest possible amount of “risk”. In academia you measure risk in “volatility”. The concept is quite simple. If you could have 8% every year with no fluctuations at all it would be optimal. It was sort of having a high yield savings account. Having 7% one year and then 9% the next year would not be desirable, and you would “lose the game”.

How to win in the game called “The Stock Market” (in Academia)?

Today I wonder my I didn’t question the obviously misperception of risk as a student. I didn’t consider myself a reincarnation of Einstein or anything, but I was quite certain I could think independently and outside the box… I clearly couldn’t.

Today I’m not saying that I don’t understand the argument about volatility. It’s nice thought to have a constant return on your investment and never have to check the stock quotes, but if you think about it, the idea of volatility as something purely bad that you want to eliminate, doesn’t really make any sense.

To illustrate this, say that I am dropping by your home and offer you a $100 bill. Here it gets tricky. Monday, Wednesdays, Fridays and Sunday you can buy or sell the $100 bill for $50. Tuesdays, Thursdays, and Saturdays, you can buy or sell it to me at $150. Does that seem like a bad business? Well for me it is! – but for you it’s amazing! I’m sure you can see where I’m going with this in this silly example. I’m basically talking about the stock market here. For the intelligent investor volatility is actually a good thing. It allows you to buy stocks when they are cheap and sell when they are expensive.

And please let me add this to the academic discussion: It completely contra dictionary to look at a portfolio with a ton of volatility, and then argue that all securities are always priced correctly. Something has to be wrong! Basically in academia we assume that returns on stocks are the same, and we further assume that volatility that is often good is what you want to avoid… I think we better move on!

How to win in the regular stock market

After graduation I started to study Warren Buffett, and quickly found that I was looking at stock investing all wrong. To keep score was actually quite simple – you simply want to maximize your returns.

With that said few people should actually avoid volatility. If you are into leveraged positions, derivatives, and other shenanigans, volatility plays a big role. But if you are looking at stock investing as a simple buy and hold strategy of great businesses (like you should), you should focus on a high return and care less about the volatility. 15% simply compound faster than 5% no matter if the volatility is high or low.

This would be a course I would love to see to be taught in more business schools. Starting from the premise that all securities are not priced efficiently, and teach young business students and future business leaders to find the very best stocks. Unfortunately you’ll have a hard time to find such a course. Bruce Greenwald, professor at Warren Buffett’s alma mater Columbia School of Business is a rare example, but the rest of us must find other sources than the traditional education system to teach us about how the stock actually works.

Why we should embrace the efficient markets!

With all the bashing you might wonder why I feel that as a society we should embrace the hypothesis of efficient markets. I think that the paradigm that you can’t beat the market gives you a very humble and respectful perception of the stock market, that are extremely valuable and a perfect starting point. I think it’s the “least bad approach for most people”. To understand this rather odd statement consider the following:

“Everyone can beat the stock market, but it takes a lot of dedication to master a complicated skill, and stock investing is no different.” It would be more honest, but also potential damaging if a beatable market was the common perception. You may have heard the statistic that 85% of all Americans believe that they are better drivers than the average. Clearly someone must be wrong right?! What would happen is everyone thought that something as lucrative as the stock market was beatable for all of us?

I predict that two thing would happen. The first thing is that the investor would start investing his life savings in different individual stock picks, and likely with a poor result because he doesn’t dedicate the countless hours it takes to master the skill. Now let me elaborate on this so I’m not misunderstood. Anyone who wanted to play professional basketball would pretty fast figure out that they wouldn’t be successful unless they were talented, worked hard, and basically dedicate their life to the sport. While I think it’s a lot easier to be a successful stock investor, what is happening is that most individual investors might spend a few hours after work a few times a month, and come up with a compelling story why he would either under or temporarily outperform the market. It would years for you to realize whether or not you are successful.

So that is what one type of investor would do if everyone believed that the market could be beaten. The investors with less confidence, but still with the same perception of the market would likely invest in mutual funds that convinced them with slick marketing saying they were “active investing and picking the best stocks”. I argued in my previous blog post why mutual funds don’t perform well and I don’t expect that to change anytime soon.

Believing in the efficient market hypothesis encourage people to buy into an index that typically performs much better than in the previous mentioned scenarios. Indexing is actually what I suggest for most people. Now I don’t want to come off wrong, and make it sound like I would recommend active investing for smart people, and indexing for less smart people. My recommendation is much more generic, and it actually reverts to what I said about dedication. If you want to put in the hours I know that you can beat the stock market. It doesn’t require a high IQ or a fancy education. If you don’t want to dedicate your time – you’ll do very well with a market index, and you don’t have to make the effort that is required to understand the ins and outs of the stock market.

When you think about it: Whether you are an experience investor, or brand new to stock investing we should embrace the idea of efficient markets. If you play your cards right and remain humble, you will at least make an average return – and that is not too bad when it comes to stocks.

~Stig

P.s. As usual, I want to hear why my analysis is wrong. If you’ve got some comments or questions about this post, be sure to leave it here on our forum.