Efficient Market Hypothesis

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According to the efficient market hypothesis (EMH), you cannot beat the market. But what if the EMH isn’t valid? And, if so, how do you achieve results over the long term?

In the May/June issue of Douglas, I discussed the theory of the efficient market hypothesis (EMH), which basically states that the current price of an asset like a stock, bond, or index reflects all of the current information that is relevant to the price of that asset. If stocks, for example, are efficiently priced, then investors cannot lock in excess profits and both technical and fundamental analysis is irrelevant. In other words, you cannot beat the market.

The validity of the EMH is a theme that academics and professionals have been discussing for several decades. In the May/June issue, I discussed the strong arguments supporting the EMH; this time, let’s look at evidence and conditions that could indicate it’s not completely valid. I like to believe in the inefficiencies because it validates some of the 50 hours per week I spend helping my clients.

One of the major tenets of the EMH is that information is efficiently dispersed to all market participants equally and prices will immediately adjust to any new information, either good or bad. After 25 years in this business, I do not believe this to be true. Not all participants are equal. Corporations, analysts, and advisors have a duty to be fair to all market participants. However, with the increased use of hedge funds and derivative instruments, large investors can react to new information faster than the average investor and, therefore, have the potential to lock in excess profits. This is not always an advantage because liquidity also plays a role that can work to a small investor’s advantage. It’s easier to buy and sell a thousand shares of an illiquid stock than a million without affecting the price of the security.

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On the whole, it’s my opinion that the larger the company, the more efficiently priced that company becomes. For example, recently I went to Yahoo finance and found that there are 17 analysts that follow IBM while there are only four that follow Badger Meter Inc. I believe that the impact of new information will be greater for smaller companies than for larger ones because the latter have a greater number of analysts who can assess the impact, valuations, and price changes on that stock.
The second tenet is that investors’ actions are random. In addition, the graphed shape of the combined actions resembles a normal distribution pattern. In layman’s terms, it means that with a large sample population, a stock will go up or down by the same percentage given a change in information. I also don’t believe this condition to be accurate. I don’t believe there is the same degree of liquidity when bad news hits, than when good news is announced. For example, I think there are more owners that want to sell when there is bad news, than people who want to buy when good news is announced. We call this the-elephant-trying-to-fit-through-the-keyhole scenario.

And last, but not least, the EMH assumes that investors react in a rational manner. During periods of extreme volatility, I think investors get irrational, especially at market tops and market bottoms. When fear and greed set in, normal behavior goes out the window.

So if the market is not completely efficient, how do you achieve superior performance over the long term? By using asset allocation models to create portfolios that meet your tolerances for risk and also allow you to choose specific positions to boost returns. In the May/June issue, I discussed the five asset classes for investors: cash, fixed income, real estate, equities, and commodities. Choosing the right mix gives you a better chance of getting the return you are looking for and still allows you to sleep at night. In addition, there is enough evidence out there that supports the view that some strategies or disciplines provide above-average returns in the marketplace. For example, in the case of mutual funds, I believe there are certain funds that have produced 10-year return numbers that have outperformed their benchmarks, as well as their peer groups. But it should be noted that the larger the fund size, the greater the likelihood their returns would start to mirror the performance of the overall market.

Now if you and a financial advisor agree that you should have 50 per cent of your assets in equities, a passive approach would be to choose a selection of exchange traded funds (ETFs), while a more active approach would be to choose a selection of top performing mutual funds or individual stocks. A third approach would be to mix ETFs with a few top performing funds or individual companies that might be inefficiently priced in the marketplace.

If you would like to learn a little more, Google Warren Buffett and read his amazing story of success and discipline. Books by Peter Lynch are also easy to read and understand and give you the basics for long-term investing. There are several websites that allow you to compare the relative merits of different mutual funds, such as www.globefund.com and www.morningstar.ca, and www.ishares.ca gives you great information on ETFs.

For those of you who want to do it on your own, some homework is required. You need to recognize that, for the most part, the market is reasonably efficient. A good starting point is to examine the composition of the ETFs. Cross reference those stock positions with the top ten holdings of the five-star funds you are researching, and then call the fund companies and ask them why they like those particular stocks. Then ask them about their favourite stock holdings and call that company. You can get the number by going to www.sedar.com. You will also want to go to www.sedi.ca. These two websites can provide you with access to most of the information including telephone numbers and the amount of stock the directors and officers hold. Most companies have an investor relations department and, if they don’t, you usually get to speak to the president or chief financial officer. If you plan on buying that stock, you should know what kind of business they are in and why.
If this sounds like too much work, contact a couple of financial professionals and see if their approach to investment management matches your own. When they make a recommendation, make sure they have done their homework and are not just reciting the latest research or marketing commentary.

Finally, a cautionary note: be true to yourself. Many investors develop unrealistic return expectations and usually end up with a higher risk portfolio. Make sure you are comfortable with the downside potential as well as the upside.