The Efficient Market Hypothesis

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Want to know how to beat the stock market? Well, according to the efficient market hypothesis (EMH) you can’t.

To paraphrase numerous textbooks and countless articles written by academics for nearly the last 50 years, the EMH states that the current price of a stock or stock market index reflects all of the current information that is relevant to that stock or stock market index. Pricing is efficient. It is, therefore, impossible to beat the market because it would be impossible to buy undervalued stocks and impossible to sell overvalued stocks and lock in excess profits.

This implies that both fundamental and technical analysis are irrelevant and the only way to outperform the market in the short run is by purchasing higher-risk securities. Academics and professionals have been arguing the validity of EMH precepts for about 50 years now and will probably continue for another 50 years.

Let’s suppose the market is efficient. (We can argue evidence of inefficiencies in the next issue.) Buying and selling stocks and mutual funds to beat the market won’t work in the long run because commissions, management fees, and other costs reduce returns below the returns of the market itself. The best strategy would be to buy indices according to your risk tolerances and income needs. Portfolio performance would, therefore, be determined by your asset allocation strategy. For example, if there were two identical portfolios and each one contained an identical mix of assets, except one only had domestic equities and the other had only international equities, there should be no surprise that over time there will be differences. Mixing the ratio of other assets will also have an impact.

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CASH
The first asset class is cash. Cash is used as a medium of exchange and a store of wealth. Its greatest feature is liquidity. Aside from currency risk (you can hold your own currency or foreign currencies to maintain your wealth), your cash investment generally does not pay a high rate of return. However, it is used for short-term spending needs and as a reserve to invest in other assets that have temporarily fallen in value. In a falling market, cash is king.

FIXED INCOME
The second asset class is fixed-income debt instruments. Common names are bonds, debentures, term deposits, guaranteed investment certificates, and mortgages. The features are a promissory to return the original sum borrowed, plus an interest component paid to the lender. Generally, the interest is fixed at the time of issue, and the largest issuers are governments and corporations. Fixed-income debt instruments can be purchased in denominations of $1,000 and most trade on a secondary market. For example, you can buy a government of Canada bond and, 10 seconds later, sell it. Pricing of all debt instruments is affected by a variety of factors, such as interest rates, issue size, credit quality of the issuer, interest payment, and term to maturity. Any change to these factors affects the price of the instrument. The recent turmoil in the financial markets was directly the result of a collapse in the credit quality of corporate-issued mortgage products. However, when an income stream is required in a portfolio, fixed-income securities should play a significant role.

EQUITIES
Equities is the term used to describe the fractional ownership of business traded in an open market, such as the stock exchange. In defined categories, groups of stocks are priced together and used as proxy to measure the general level of equities as a whole. In the U.S. market, the most famous is the Dow Jones Industrial Average, which is an aggregate of thirty large American companies.
In today’s sophisticated world, investors have the ability to purchase individual stocks (equities) or groups, such as indices, in both domestic and international denominations. In addition, investors can now purchase or sell derivative instruments, such as options and futures, which give the investor the right to buy or sell securities for a specified time into the future (for sophisticated investors only).

REAL ESTATE
For many Canadians, real estate is the biggest portion of their net worth. Real estate has many advantages as a long-term store of wealth and cash flow. However, under certain economic conditions and cycles, real estate can produce significant negative returns. For investors, real estate can be purchased directly, like a second home or revenue property, or indirectly through the purchase of limited partnerships or companies that invest in real estate. Liquidity, cash flow, and capital-appreciation potential are primary criteria. For many investors, purchasing additional real estate for inclusion in an investment portfolio becomes a difficult proposition and, therefore, they choose the easier method of purchasing real estate investment trusts or real estate companies.

COMMODITIES
Commodities used to be the domain of farmers and miners and their customers, and speculators. If you were a wheat farmer and wanted to pre-sell your next crop, you could enter into a transaction with a commodities trader at negotiated price and delivery date. A large food chain restaurant might be worried about the price of bacon it sells to its customers and, therefore, enters into a contract to buy pork bellies for delivery six months down the road. Speculators, on the other hand, never intend to make or take delivery of the underlying commodity. Instead, they bet on the price change during the life of the contract and locks in a profit or loss. Since contract sizes are large, the use of leverage becomes necessary, which means small price changes produce large swings in profits. Generally, it’s not for the faint of heart or small investor. However, recent innovations in financial products allow small investors to gain exposure with commodity instruments, and these instruments tend to do well during periods of rising inflation.

So how does one put this all together?
First, consult a professional. Your starting premise is that you are not going to try and beat the marketplace, but that you want an acceptable level of return for your risk comfort level. From there, it is necessary to look at the long-term performance numbers and the volatility of each asset class and sub-class and weigh that against your comfort level. Your income needs and time horizons will play a significant role in the composition and selections. And make sure you consider all of the asset classes described above.