Investing is an exciting prospect! If you pick the right companies, a dollar invested today might be worth two dollars tomorrow. As long as you pick the right companies. If you pick well, your nest egg will grow and you’ll retire in prosperous comfort. As long as you pick the right companies…
CNBC says I should buy General Motors. The Wall Street Journal says I should buy Ford. But the Motley Fool says we might be on the verge of a bear market, and I shouldn’t buy anything! Who is right? There are so many choices, so many buyers and sellers, so much information. How does a simple individual like me stand out from this crowd to make my profit?
I ask, I answer: the Efficient Market Hypothesis
This question—how can one person stand out from the crowd and repeatedly beat the market for a profit?—is the heart of the efficient market hypothesis (EMH). There are a few different variants of EMH**, but they all share a few common sense assumptions. First, EMH is built upon the fact that market is comprised of many buyers and sellers (or “agents”). The market isn’t just a few dozen dudes shouting numbers and holding up their fingers at the stock exchange. It’s thousands and thousands of very smart people (and their computer programs), devoting their working lives to the task. Second, EMH assumes that these agents are all working off of a common set of information, and that new information spreads very quickly. These agents all know about different companies’ profit reports and future projections, about past performance and CEO history. Some agents will come to more conservative conclusions from that information, while other agents might be more optimistic. Individual agents aren’t perfect, and might overprice or underprice an individual stock. But as a whole—as a market—the price of a stock will accurately reflect all available information. The overpriced agents and underpriced agents will average out, and the price that the market settles on will be reflective of the stock’s true value. That’s the heart of EMH.
Does the Efficient Market Hypothesis have legs?
Are these assumptions valid? I’d say so. As consumers, we have lots of choices of mutual funds, managed funds, stock brokerages, etc. There are thousands of people out there trying to make money in the market, trying to find little edges here and there. So yes, there are many agents out there. And in our information-rich society, it’s easy to see how all of these agents share information. What do I mean? By the time you hear about a hot tip, it’s probably too late. For example:
9:00 AM: General Electric releases a great earnings report. Things are looking good for the company.
9:05 AM: Agents who closely monitor GE see the news. The information affects their evaluation of the stock. Through their buying/selling (mostly buying, since the report was positive), that information enters the market.
9:15 AM: The demand for GE stock is increasing. More people want to buy it than sell it. The price starts going up.
9:30 AM: Agents who look for trends in the market see that something is up with GE. They use the Internet to quickly find the positive earnings report. Although the stock price has already increased 4% over the past 30 minutes, they think it still has room to grow. They buy in.
5:00PM: Over the day, the information continues to spread. Investors look at GE, but see that it’s already gone up significantly today. “Is there any more profit left for me?,” they wonder. “Is it still undervalued? Will it continue to go up?” Fewer investors are willing to buy in, and the price begins to settle. The market closes. GE price went up 7% today.
6:30PM: I see on the CNBC show “Mad Money” that General Electric had a great day. 7% in one day! The information has spread to me. I think, “It’s hot, I should buy it!”
Next day, 9:00AM: As a “smart” stock picker, I follow the “expert” advice and buy General Electric for the new price, 7% higher than it cost yesterday morning.
What’s the issue? The point of buying a stock is that you think the stock is undervalued, and that the price will go up in the future. But in my simple example, you can see how the speed of new information caused the price to go up before I bought it. The market reacted to the good news quicker than I did. I bought the stock at a price which the market had already decided was accurate to the true value of the company. There is no “undervalued” for me, no promise that stock will continue to go up in the future. By the time I reacted, it was too late.
We can conclude the assumption of “information is shared, and shared quickly” makes sense. What’s left for me to make my profit? The only way to beat the market is to 1) obtain and process information before everyone else, 2) process that information correctly, and 3) do so consistently. And EMH states that these three requirements are simply too much for an individual to do. There is too much competition—too many other agents—for any one person to be faster, better, and more consistent. If you try to handpick winners and losers, EMH states that you’ll probably end up performing exactly the same as the entire market, and any variation from that (e.g. if you outperform the market) is simply random. You’ll make some picks that make you look genius, but those will be mitigated by the picks that make you out a fool. In good times, you’ll probably do well. In bad times, you’ll probably do poorly.
So, what’s wrong with that? Well, for one, you’re probably going to spend time to hand-pick these stocks. You’ll read, watch financial shows on cable TV, maybe play around with a spreadsheet or some graphs. And second, you’ll be charged fees to buy and sell. If you’re actively trading, you might be buying and selling a lot. Those fees will add up. You’re spending time and money to hand-pick stocks, and EMH states that you won’t perform any better than the market as a whole. Or, if you let an “expert” hand-pick those stocks on your behalf, you’ll save the time but also surely pay more in terms of an expense ratio fee. “Expert” stock pickers tend to charge more for their wizardly opinions than someone who simply says, “Don’t hand-pick stocks. Just buy the whole market.” Either way, you’re spending time and/or money to hand-pick stocks, and EMH states that your end result will not improve.
Next post, I’ll be back with some arguments against the EMH. But I’ll also talk about why the EMH should push you towards investing in low-cost index funds.
Thanks for reading!