The annoying efficient market hypothesis and how to beat it
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The annoying efficient market hypothesis and how to beat it

Oct 2021
Mar 2019
"I'd compare stock pickers to astrologers but I don't want to bad mouth astrologers."
  • Eugene Fama, "Father of modern finance", 2013 Nobel Laureate, University of Chicago Professor, Dimensional Fund Advisors Director

Have you ever tried to sell something on Craigslist or Carousell? It could have been a pair of pants, a piece of furniture, a bicycle, or something completely random. The item itself is not important: if you try to sell it for too high a price, it does not move. If you set the price too low, you will get a ton of inquiries and be kicking yourself for underpricing. Naturally, we are always trying to get the highest price possible, that the market (a buyer) will accept.

Let's now shift this concept from selling used items to the greatest market on the planet: the financial markets. In 2017, there was over US$400 billion traded on average per day on the global stock markets. All of that money, irrelevant of who was behind it (a sovereign wealth fund, a college student, a high-frequency trader, a billionaire), is trying to find a deal and set new prices, constantly.

We are all participating in a market where the value of goods and services is relative and constantly on the move.

The efficient market hypothesis is annoying - we can seldom get a great deal.

But it is also comforting to know that you will seldom get terribly ripped off. You will likely walk away with a 'fair' deal, most of the time.

Eugene Fama, 2013 Nobel Laureate, is credited with developing the Efficient Market Hypothesis, on which intelligent investment decisions can be made.

The efficient market hypothesis simply states that:

  • Current prices incorporate all available information and expectation.
  • Current prices are the best approximation of intrinsic value
  • Price changes are due to unforeseen circumstances
  • "Mispricings" can certainly occur, but not in predictable patterns

It absolutely does not state that:

  • All investors are rational
  • Prices are always right
  • Prices should be stable

Let's not ignore market pricing

market pricing formula

The markets are living, breathing, and reflecting data constantly. Prices move around as people and institutions act on their convictions. At any point in time, a price is an amalgamation of the aggregate human view. Prices can absolutely be wrong- you can spot this and act on it, and feel pretty good when the markets move in your direction.

Unfortunately, it is almost impossible to beat prices persistently and consistently.

Professionals who look at the market all day and night cannot beat the market. Morningstar, one of the most well-known fund rating companies, rates on a one to five-star system. The number of five star rated funds that will remain five stars just three years later is a meagre 14%. The persistence of returns over the market is non-existent, and playing that game is a low confidence endeavour.

Read more: The Morningstar Mirage (WSJ)

In fact, the number of people who do beat the market is less than that due to random chance - a depressing statistic on the human condition.

The next time you hear friends say "it is so obvious that this stock will go up," pause and think of the market, and the $400 billion transacted per day looking for the right price. Your friends may be right, but they are betting against the market which has already incorporated their view and that of all of the other participants.

We also often hear people say "Asia is different," or "Only the US markets are efficient." Even if it is true that some markets are more 'efficient' than others, unless you are getting a steady stream of insider information and acting on it (which is absolutely illegal) why would you operate and make decisions in any other way?

Now, the market is great - but can we beat it systematically?

Academic research and efficient implementation over the last few decades has told us that it is possible.

Watch: In pursuit of the perfect portfolio: Eugene Fama (38 mins by MIT Labs)

Systematically building a portfolio that buys more small-cap, cheap (value), and profitable companies can lead to out-performance over the long-run. This phenomenon is persistent across longer time frames and markets. This out-performance does not happen consistently every year, but rewards investors patient enough to sit out the volatility, and maintain their course.

Small, Value & Small+Value versus the Market

table of returns of small cap indexes over time

We have written on these factors before, in case you are interested: Making small-cap investing work (Part I), Making small-cap investing work (Part II), Choosing the right rocks (& stocks), The value risk premium in equities investing

Dimensional Fund Advisors, an asset management firm founded in 1981, systematically pursues these anomalies. Their long-term benchmark-beating track record demonstrates that these anomalies can be exploited and captured through broad diversification in a cost-efficient manner.

Let the prices work for you. There is no need to bet against the market to beat the market.

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