Why the Efficient Market Hypothesis Is Bunk
“I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient market hypothesis.”
– Michael Jensen, Harvard Business School professor emeritus of business administration
You may have heard of the efficient market hypothesis (EMH).
Put simply, it states that stock prices reflect all information in the markets.
As a result, a stock will always trade at its fair value.
That, in turn, makes it is impossible to “beat the market” consistently.
So you should give up on picking stocks and invest all your money in index funds, right?
By matching the market, you will ensure that you end up better off than most investors – with next to no effort.
That’s a compelling argument… and one that is tough to refute.
Nevertheless, today I want to reveal why I think the EMH is bunk…
And why you should devote at least a part of your portfolio to trying to beat the markets…
An Idea With an Illustrious Pedigree
To mainstream financial economists, the EMH is an article of faith.
Eugene Fama of the University of Chicago developed the EMH in the 1960s.
Princeton professor Burton Malkiel popularized it in the 1970s in his best-seller A Random Walk Down Wall Street.
Like John Bogle, the founder of Vanguard index funds, Malkiel argued that the best strategy as an investor is to buy the entire stock market through a traditional S&P 500 index fund.
Even Warren Buffett recommends investors buy low-cost S&P 500 index funds and stay in them for the long term.
Do as I Say, Not as I Do
The EMH is a product of the 1960s and 1970s. But economists had very different views both before and after it became the accepted religion in academia.
English economist John Maynard Keynes developed a reputation as an outstanding investment manager of Cambridge’s Kings College Chest Fund endowment from the 1920s through the 1940s.
Keynes believed that you could achieve outstanding results by making large contrarian bets on undervalued stocks.
Plenty of economists preach the water of efficient markets but drink the wine of active investing.
The late MIT professor Paul Samuelson – the first Nobel Prize winner in economics – published a 1965 paper in support of the EMH.
Ironically, Samuelson personally made a fortune as a founding investor of Commodities Corporation, a secretive trading group that produced some of the greatest traders in history. (He was also a significant investor in Berkshire Hathaway in the 1970s.)
University of California, San Diego professor Harry Markowitz never invested his own pension fund using the EMH… for which he earned the Nobel Prize.
But the economics profession has come around in recent years.
Yale’s Robert Shiller won a Nobel Prize for highlighting the importance of mass psychology in the markets. In his 2009 book, Animal Spirits, Shiller (along with UC Berkeley’s George Akerlof) argued that investors make decisions based on emotion rather than on the rational assessment of underlying value.
Just think of the stock market crash of 1987, the dot-com bubble of the 1990s… or even cryptocurrencies today.
Why EMH Is Bunk
Here’s why I think the efficient market hypothesis fails to stand up to evidence…
Just because the average investor does not beat the market does not mean that no investors beat the market.
Think of investing like playing in a chess tournament.
In chess, a few high-level players will win almost all of the games.
In investing, a few top traders will consistently outperform the markets.
In both cases, the participants have the same information.
But the high-level participants interpret this same information differently from the majority.
Here’s the most surprising point…
In both chess and investing, exploiting the mistakes of the majority creates profitable opportunities for the few but far more skilled.
As chess grandmaster Garry Kasparov has pointed out, in chess, mistakes are driven by emotion.
You can say the same for investing.
It’s emotion that causes mistakes and irrational behavior.
That’s how market prices can get so far out of line.
So I have two takeaways for you today…
If you are a casual investor, take Buffett’s advice and invest all your money in an S&P 500 index fund.
Better yet, invest in Chief Investment Strategist Alexander Green’s Gone Fishin’ Portfolio to both reduce your risk and boost your long-term returns.
But if you’re committed to beating the market…
Just as a serious chess player is committed to mastering chess…
Don’t be discouraged by the efficient market hypothesis.
Yes, it is hard as heck to beat the market…
But it is hardly impossible.
Good investing,
Nicholas
