In this post, I am going to discuss the Efficient Market Hypothesis that applies to the stock market. I hope to show that the people who believe this hypothesis unquestioningly and the people who do not believe in this hypothesis at all are both wrong, and for the same reason.
First of all, two definitions, that at least one of which you might decide is a fair description.
First WikiPedia’s definition:
In finance, the efficient-market hypothesis (EMH), or the joint hypothesis problem, asserts that financial markets are “informationally efficient”. In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.
Next is a definition from Investopedia:
An investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.
I think these two definitions are consistent enough that we can conclude that there is little controversy about the definition.
With the recent history of the world-wide financial collapse, there are now many doubters who claim that the Efficient Market Hypothesis is ridiculous. All the economics professors and trading professionals who have built a huge theoretical structure and numerous computer programs around the theory are obviously fools according to the many dissenters. Both the true believers who think that there is a universal rule that says markets are efficient and the doubters that say there is no such thing as an efficient market are both forgetting something.
There is a reason why the market has been fairly efficient for almost 50 years or more since the Great Depression, but has not been so efficient lately.
After the collapse of the Great Depression, laws were enacted and strictly enforced that required stock markets in this country to be open about all important information relating to the investments sold in these markets. Rules mandating disclosure of all relevant facts about an investment and rules against insider trading using any facts that had not been disclosed to the trading public have made these markets fairly transparent in the time frames most important to investors.
Before the Clinton administration and culminating in the repeal of the Glass-Steagal act in that administration, these rules which made for an efficitient market have been chipped away. Where the rules were not being chipped away, the enforcement of the rules that were still on the books was weakened and weakened.
If you need any proof of this, there is no greater expert than William Black. See the latest installment of words of wisdom from him in the previous post, Documents in JPMorgan settlement reveal how every large bank in U.S. has committed mortgage fraud. Funny that they could send Martha Stewart to jail for insider trading, but have not been able to do so for the really big fraudsters.
The lesson to be learned is that the fact of efficient markets is not some immutable law of the universe. To the degree that markets are efficient, they get that way through human effort to make them that way. It makes sense to offer up theories on the consequences of efficient markets, how to make the most of them, and how to set up an economy that depends on them. However, you must remember that efficient markets are created, and their efficiency can be destroyed.
The naysayer who believe there is no such thing as an efficient market, forget how such a market was created after the Great Depression. They want to get away from a market system, despite the proof that it can be made to work well for long periods of time.
So, I urge both sides to understand the basic history of the successes and failures of markets in order to resurrect an efficient market that can serve the economy well.
December 1, 2013
In response to some comments on Facebook by JoãoG, I thought an addendum would be appropriate. The above definitions of the Efficient Market Hypothesis has gotten me into the trap that is a common problem in Economics. Let me restate one of the definitions in a way that will help us avoid the trap.
The Efficient Market Hypothesis states that if a stock market is 100% efficient, then it is impossible for an investor to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.
So the real question is not whether or not the market is efficient. The real question ought to be, is the market efficient enough? Of course, there is another flaw in the definition of the EMH.
According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
What makes a market is that some people want to buy at a given price and some other people want to sell at that price. Otherwise there could be no transaction.
Why the seeming difference of opinion if the market is so efficient? Different investors have different goals at any given moment. What suits the buyer’s goals is not what suits the seller’s goals, so they can make a transaction that satisfies both of their goals.
Taking the Efficient Market Hypothesis into account, my investment goal has never been to “beat the market”. My goal has always been to do well enough to support my family’s life style. However, the investment strategy that I have adopted is one in which I buy a stock when it is undervalued, and sell it when it starts to get to overvalued. The EMH seems to say that this is impossible. Well, all I can say is that I buy it when it is undervalued for my goal, and I sell it when it is overvalued for my goal. My goal is to generate a steadily rising dividend stream to support my current retirement.
Before my retirement, I had a different goal of wanting to build a nest egg that would be large enough to support me in retirement. During that phase of life, using dollar cost averaging into an index fund would have worked well enough. Such a strategy only depends on the long history of the U.S. stock market of rising at an average rate of 10% a year over long periods of time. That strategy does not violate the simply stated EMH.
There is no exact analog to dollar cost averaging when you want to take money out of your investments during retirement. That is why I settled on the dividend strategy for retirement. Of course, my current strategy does allow for portfolio growth over the long haul, without interfering with a steadily growing dividend stream as long as I don’t try to milk my nest egg for too high a dividend stream. That and Social Security helps a lot.