“The true value of academic research isn’t that really smart guys who understand things better than we ever will come up with it—the true value is that it identifies what we need to focus on to succeed, and helps us to understand it. Investment theory simplifies things that are otherwise shrouded in mystery and confusion.” — Eugene Fama
Eugene Fama of the University of Chicago is one of three economists just awarded the Nobel Prize in Economics. Fama is best known for his formulation of the “efficient market hypothesis,” or EMH. The MIT Dictionary of Modern Economics defines the EMH as “The view that the prices of shares on the stock market are the best available estimates of their real value because of the highly efficient pricing mechanism in the stock market.”
It is doubly appropriate that the EMH includes the word efficient because it happens to be an extremely efficient theory. Milton Friedman wrote that an economic theory is important if “it explains much by little.” The EMH does that about as well as any economic theory ever has. In fact, Professor Fama’s elegant hypothesis is almost too concise. Because it says so much in so few words it is all too easy to overlook its significance.
For investors the main practical implication of the EMH is that attempting to “beat the market” is a costly and futile endeavor, at least when beating the market is accurately defined. Truly beating the market means that an investor achieves excess returns beyond what are the average returns for the overall market or some segment of the market. Beating the market also means making excess or abnormal returns without taking additional risk. The two primary dimensions of investing are risk and return.
What is probably the most common logical error investors make is believing that the key to making excess returns is in identifying good companies, ones with good management selling good products--Apple, for example.
Investing in Apple stock, however, will not necessarily generate above average returns. All the favorable news about Apple is well known and already reflected in its price.
If excess returns are possible the key is in finding mispriced stocks. What you’re looking for are stocks that will go up faster than the overall market. In other words, you’re looking for bargain-priced or mispriced stocks.
The stock market is perhaps the most highly competitive environment that’s ever existed. Furthermore, stock prices are highly flexible. Whenever a mispriced stock is identified and investors attempt to buy it, its price will be bid up until it is no longer a bargain.
"Each investor, using the market to serve his self-interest, unwittingly makes prices reflect that investor’s information and analysis. It is as if the market were a huge, relatively low cost, continuous polling mechanism that records the updated votes of millions of investors in continuously changing current prices. In light of this mechanism, for a single investor (in the absence of inside information) to believe that prices are significantly in error is almost always folly. Public information should already be imbedded in prices." -- Mark Rubinstein, “Rational Markets: Yes or No? The Affirmative Case.”
In the end, the quest for a market-beating strategy boils down to an information-processing contest. The entity you are competing against is the entire market and the accumulated information discovered by all the participants and reflected in prices. The efficiency of market prices will define whether or not you have any realistic hope of winning the contest.
Many investors and mutual funds ostensibly beat the market over short periods of time. The question is, however, was it because of luck or skill? Skill persists, luck is random and transitory. Reliance on luck is not a wise investment strategy.
Market efficiency turns out to be good news for all the participants. Let’s say you inherit Exxon stock from your Aunt Clara. If you want to convert it to cash, how can you know you will get a fair price? If stock prices promptly reflect all available information, you can be confident that you will not be ripped off. The price you receive is the same as all the other market participants pay or receive. It is a level playing field.
The EMH happens to be a specific application of a more general economic theory known as “rational expectations.” The theory of rational expectations is the theoretical context for the EMH. “Rational expectations: The application of the principal of rational maximizing behavior to the acquisition and processing of information for the purpose of forming a view about the future” (MIT Dictionary of Economics). The 1995 Nobel Prize for economics was awarded to Robert Lucas, also of the University of Chicago, primarily for his work in developing the theory of rational expectations. An understanding of rational expectations is the easiest way to understand why Keynesian policy prescriptions don’t work. (That is something I discussed in an earlier column, “Fatal Flaws of Keynesian Economics.”)
The main practical implication of the EMH is the superiority of “passive management” (which means matching market returns) rather than “active management” (meaning the pursuit of excess returns). Another name for passive management is “asset-class investing.” Index funds, such as an S&P 500 fund, are also applications of passive management.
If you accept the assertion that markets are efficient, you will avoid individual stocks and “market timing.” Both strategies will increase your risk exposure and not increase your expected return. It’s best to avoid thinking you’re smarter than the market.
A common misunderstanding about efficient markets is thinking they are equivalent to being error-free. The market makes countless mistakes that are easy to identify after the fact. There is no profit potential in seeing pricing errors retrospectively.
Fama’s logic regarding market efficiency so impressed two of his graduate students, Rex Sinquefield and David Booth, that they started a mutual fund company to apply what they had learned. The company, Dimensional Fund Advisors, is now one of the largest mutual fund families with over $300 billion under management. Because of Booth’s $300 million endowment to the University of Chicago, the graduate school of business there is now called the University of Chicago Booth School of Business. Fama serves on DFA’s board of directors and actively participates in research and consultation at the firm.
My book, The Unbeatable Market, goes into depth about market efficiency and its implications for investors and investment advisors. Like many principles of economics, market efficiency is counter-intuitive. Before such principles can be believed it’s often necessary to go below the surface.
Professor Fama has clearly identified “what we need to focus on to succeed.” His contributions have definitely simplified “things that would otherwise be shrouded in mystery and confusion.” Such contributions unquestionably deserve a Nobel Prize. One remaining mystery is why it took the Nobel committee so long to recognize that.
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