As we have said, the legend of alpha has convinced us that mere mortals can indeed beat the market if we just know the tricks and the secrets. You can read everything Mr. Buffett ever said, but you will never be Mr. Buffet. Mr. Buffett has a preternatural brain that takes in thousands and thousands of data points (news) and seizures on the very few that have market-moving potential. You and I can watch CNBC all day every trading day and still never make any money more than what we would make following Mr. Buffett’s advice and buy an index fund.
The Efficient Market Hypothesis
Theorized in the 1970s by Eugene Fama, the efficient market hypothesis (EMH) is an investment theory that states it is impossible to “beat the market,” because stock market efficiency causes share prices to always incorporate and reflect all applicable data. According to the EMH, stocks always trade at their fair value in the markets. The corollary to this strange fact means that it is impossible for investors to either purchase undervalued stocks or sell stocks at extravagant prices. If the theory is correct, it should be impossible to outperform the overall market through expert stock selection or market timing. It states that the only possible way an investor can obtain higher returns is by purchasing riskier investments. Again, we find a theory that tells us that there is no free lunch on Wall Street!
While it makes stock pickers and technical analysts everywhere bristle with indignation, the EMH is a cornerstone of modern financial theory. As you would expect given the thousands of highly paid professionals that become worthless if the theory holds, the EMH is highly controversial and often disputed. Supporters of the theory argue that it is pointless to search for undervalued stocks or to try to predict market trends through fundamental analysis or technical analysis (or any hybrid of the two).
Academics point to a large body of research that supports of EMH, yet a great amount of opposition also exists. For example, investors such as Warren Buffett have consistently beaten the market over long periods of time, which, according to the EMH, should be impossible. Critics of the EMH also point to events, such as the 1987 stock market crash when the Dow plummeted over 20% in one day, as evidence that stock prices can seriously deviate from their fair values.
It is ironic that the detractors of the theory point to the investment record of Mr. Buffett as a contradiction of the idea. One of the staunchest advocates of the idea that you (not him) cannot beat the market and you will lose time and money if you try. In fact, Mr. Buffett made a very large bet (with the proceeds going to charity) that a group of the finest investors on Wall Street could not beat a strategy of buying and holding the S&P 500 over a ten-year period.
In 2007, the famed billionaire investor made a $1 million bet that an S&P 500 stock index fund would outperform a basket of hedge funds over the course of a decade. The index fund returned 7.1% compounded annually over the 10-year period, easily beating the 2.2% average return of a basket of funds picked by asset manager Protégé Partners. There are two major lessons here. First, never, ever bet against Warren Buffet. Second, do what Mr. Buffett says, not what Mr. Buffett does. This is primarily because you cannot.
My take on the EMH is simple. The markets are mostly efficient most of the time, but with random and violent breaks with efficiency from time to time. Since these breaks are random, you cannot predict the direction, magnitude, or timing. To effectively game the market and find alpha, you need to be able to do all three. Otherwise, you are left with a reward that is commensurate with the risk you are willing to take on in your portfolio.
Last Updated: 6/25/2018