Markets
Don't Have to Be Right to Be Efficient
The recent
internet-stock experience and the vogue for "behavioral finance"
have people really questioning the Efficient Markets Hypothesis
(EMH). This is nothing new. The EMH has been contested since its
debut thirty years ago. Usually, critics say it's a fanciful idea
that looks good on paper but in the end is irrelevant because
it doesn't explain some quirky (and usually recent) behavior of
prices.
The very fact
that the hypothesis still comes under assault is stronger testimony
to its deep relevance. People don't argue about irrelevant ideas
and the EMH still dominates the research agenda. It has stood
through endless testing and debate with almost no modification
because simply repeating its core ideas dispatches most objections.
These core ideas are useful to consider while investing, and are
all too often misunderstood.
In a nutshell,
the EMH purports that markets are full of people trying to maximize
profit by predicting the future values of securities based on
freely available information. Many intelligent participants compete
to trade at a profit. The price they strike in trading a stock
is the consensus of their opinions about the stock's value. This
is based on all their information about the stock, everything
they know that has happened in the past and everything they predict
will happen in the future. The end result is that the price of
the stock is usually a good estimate of its intrinsic value.
Critics often
challenge the notion that investors on the whole are informed
enough to price stocks correctly by consensus. Most investors
can't possibly know that much about any given stock. But market
efficiency doesn't require that most investors have information.
It only requires that "many intelligent participants" have information.
In fact, no single investor has that much information. Even the
smartest, most savvy guy has only a tiny fraction of all the information
out there. Information isn't a big secret squirreled away somewhere;
it is widely distributed in little pieces. The market functions
as a mechanism that gathers the information, evaluates it, and
builds it into prices.
This is what
it means to say prices are a consensus view of a stock's value.
At some level every investor includes (or doesn't include) a security
in his or her portfolio until the stock's value to the investor
is about equal to its market price. Since the price is the same
for everyone, so is the value. Now granted, if everybody investing
is wrong, prices might conceivably be poor estimates of value.
For this to happen on any scale, the ignorant investors would
have to be overly optimistic or overly pessimistic as a group.
Otherwise, the optimists will cancel out the pessimists and the
price struck will be rational. Since stocks are more likely to
trade when the person selling is pessimistic and the person buying
is optimistic, prices on average are more likely to represent
rational consensus.
Admittedly,
sometimes it can be hard to view prices as rational. We see stocks
with no assets other than a website and with little or no profit
suddenly become bigger than General Motors only to melt down a
year later. How can such prices be good estimates of value? They
seem so illogical, possibly the consensus view of ignorant day
traders and kids with e-accounts chasing fads.
Let's suppose
for the sake of argument that investors behave like lemmings and
that the market systematically misprices stocks. Such a market
would surely be child's play for a smart investor with real analytical
skills. The reason such successes are hard to identify is that
there's more than just one or two smart investors out there. There
are thousands of savvy analysts looking for over- or under-valued
securities. The opportunities to generate excess profit are diminished
when these investors trade away disparities between a stock's
price and its intrinsic value.
The EMH does
not claim markets are always perfectly rational or that the information
reflected in prices is always correct. The consensus view of investors
can temporarily result in prices well above or well below a stock's
intrinsic value. The only condition efficient markets require
is that a disproportionate number of market participants does
not consistently profit over other participants.
After taking
risk into account, do more managers than you'd see by chance outperform
with persistence? Virtually every economist who studied this question
answers with a resounding "no." Mike Jensen in the Sixties and
Mark Carhart in the Nineties both conduct exhaustive studies of
professional investors. They each conclude that in general a manager's
fee, and not his skill, plays the biggest role in performance.
Since mutual funds report performance after deducting fees, the
bigger the fee, the worse the performance. Aside from that, expert
investors with nearly unlimited resources working around the clock
can't seem to outpredict the market.
This means
investors are better off avoiding active managers—especially pricey
active managers. History shows that in the long run a thoughtfully
designed, diversified strategy of "passive" funds typically beats
all but a few active managers. It's not easy to structure and
maintain such a strategy. It requires some initial research and
discipline to stay the course. But it’s much easier than predicting
which active managers will randomly beat this approach. |
