Investing is an exciting prospect. But today, we’re going to discuss why stock picking is hard. We’ll talk about the “efficient market hypothesis,” and why you should understand it. And then, in light of “EMH”, what might a simple investor do?
Stock picking is exciting!
A dollar invested today might be worth two dollars tomorrow. If you pick the right companies.
Your nest egg will grow and you’ll retire in prosperous comfort. If you pick the right companies.
Catch a theme, here? How do I pick the right companies? I guess I’ll see what the stock picking experts say.
CNBC says I should buy General Motors. The Wall Street Journal says I should buy Ford. But the Motley Fool says we’re in 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?
Enter the Efficient Market Hypothesis (EMH)
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).
It states that the market processes information efficiently. The market is really smart–probably smarter than you. The prices that the market sets are accurate. Therefore, the odds that you’ll be able to pick the right companies–buy low, sell high–are low. Beating the market is tough to do.
There are a few different variants of EMH, but they all share a few commonsense assumptions.
Assumption #1: Many agents
First, EMH is built upon the fact that the 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 of stock picking.
Why does this matter? Because large groups of experts tend to come to better consensus decisions than small groups of ignoramuses.
Assumption #2: Agents share information
Second, the efficient market hypothesis assumes that these agents are all working off of a common set of information and that new information spreads quickly.
The agents all know about different companies’ profit reports and future projections. They know about past performance and CEO history. If stock picking was a test, then EMH assumes that all the agents have attended the same classes and use the same textbooks. All agents know information equally
Some agents will come to 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.
Different versions of EMH
My explanation is simple and won’t satisfy some of you. I know I’m leaving some details out. Let me explain the three well-known variants of EMH.
These variants carry different opinions about how much the agents know, and how quickly the agents gather their information.
Do the agents only get to see past information? Are they up to date on all the public news about a company? Do nosy agents even get to hear private information about a company?
Strong form EMH
The strong form of EMH states that stock prices reflect all information about a company. Past info, public info, and private info. There’s a strong connection between information and the market
Let’s say you want to invest in the Best Interest Group, a well-known media conglomerate.
BIG just decided that it will start a blog about baking cookies. This decision occurred in a private meeting among BIG executives. BIG will put a team together to bake cookies, run taste tests, write recipes, etc. This will all be done internally at BIG until the blog is launched (and made public).
According to strong form EMH, BIG won’t be able to keep its secret. Employees will talk. Rumors will spread. Information will percolate into the market–that cookie was so good!–and the market will react.
Stock picking will occur and the price of BIG will reflect its new cookie venture before the cookie news goes public.
Semi-strong form EMH
The semi-strong form takes a step back from the strong form. It states that public information instantly affects stock prices, but that private info stays private. There’s a semi-strong connection between information and the market.
This is the form that is considered most accurate.
The cookie blog doesn’t affect BIG‘s stock price until BIG shares news of the blog with the public. At that point, the market agents immediately react to the news. The agents evaluate the new info and decide to buy, sell, or hold their shares of BIG. Those purchases and sales immediately affect the price of BIG shares.
Weak form EMH
Weak EMH differentiates itself because it believes that the agents don’t immediately react to new public information. Instead, the agents are aware of all past information only. Future price changes are random. How might that work?
You notice that the price of BIG has decreased on six consecutive Tuesdays and increased on six consecutive Thursdays.
Boom. You’ve got a plan. Buy on Tuesday afternoon (after a decrease) and sell on Thursday afternoon (after an increase).
But weak EMH states that stock prices only reflect past market information, and any connection between past and future prices is random.
The pattern you saw–six consecutive weeks–is just like flipping a coin heads-up six times in a row. It’ll happen occasionally. But it has no bearing on whether the seventh flip with be heads or tails. It’s just randomness.
If you buy next Tuesday and sell next Thursday, your stock market success will be a coin flip.
Summary of the three forms of EMH
Weak form EMH – the market only accounts for past information. Future price changes are random.
Semi-strong form EMH – the market accounts for past information and present public information.
Strong form EMH – the market accounts for all information – past, public info, and private info.
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Does the Efficient Market Hypothesis have legs?
Are these assumptions valid? I think so.
There are thousands of people stock picking in the market, looking for 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 stock picking tip, it’s too late. For example:
Big news from BIG
9:00 AM: Best Interest Group releases a great earnings report. Things are looking good for the company.
9:01 AM: Agents (most likely computerized) who monitor BIG see the news. The information affects their evaluation of the stock. They start buying BIG.
9:05 AM: The demand for BIG stock is increasing. The price starts going up.
9:10 AM: Agents who look for trends in the market see that something is up with BIG. They use the Internet to find the earnings report. Although the stock price has already increased by 4% over the past 10 minutes, they think it still has room to grow. They buy-in.
5:00 PM: Over the day, the information continues to spread. Investors look at BIG but see that it’s already gone up.
“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 as prices rise, and the price begins to settle. The market closes. BIG went up 7% today.
6:30PM: I see on “Mad Money” that BIG had a big day. Jim Cramer (no relation) plays lots of sound effects. The information has now 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 Best Interest Group for the new price, 7% higher than it cost yesterday morning.
Big problems with stock picking
What’s the issue?
The point of buying a stock is that you think the stock is undervalued. You think the price will go up in the future. But in my simple example, 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 at a price that the market already decided was accurate to the true value of the company. By the time I reacted, it was too late.
We can conclude the assumption of “information is shared quickly” makes sense.
What’s left for me to make my profit? The only way to beat the market is to:
- Obtain information before everyone else
- Process that information correctly
- Do so consistently.
EMH states that these three requirements are 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 end up performing the same as the entire market, and any variation from that (e.g. if you outperform the market) is random.
Some stock picking will make you look genius, but those will be mitigated by the picks that make you out a fool. In good times, you’ll do well. In bad times, you’ll do poorly.
What’s wrong with average stock picking?
First, you’re 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.
Second, some brokers charge fees to buy and sell. 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 pay more in terms of an expense ratio fee.
What’s the alternative to stock picking?
Just buy the whole market. There’s no long-term advantage to hand-picking individual stocks. EMH concludes that paying high fees for “expert” opinions is a waste of money.
Any above-average performance is random, like a monkey throwing darts at a board. The monkey might hit a bullseye, but does that make the monkey an expert darts-man? (Hint: no, it does not make the monkey an expert darts-man).
Your best bet is to pay the smallest fees possible to buy a share of the whole market. How do you do that? They’re called index funds, and they have been revolutionizing the financial markets since the 1970s. Some of you might have heard about a problematic index fund bubble–I cover that too.
More reading about index funds:
Could EMH be wrong?
While EMH makes sense, it isn’t gospel. It’s just a hypothesis, and many economists are taking a scientific approach to poke serious holes in the theory.
For one, market agents have biases, and sometimes those biases won’t “average out” over the whole market.
And two, sometimes people are just dumb. Here’s a recent example comparing Zoom Video Communications against Zoom Technologies. The former makes the video conferencing software that has exploded in popularity due to COVID 19. The latter is a different company making a different product.
But you wouldn’t know that by looking at their stock prices.
While the “right” Zoom was up 100% (since the beginning of 2020) by mid-March, the “wrong” Zoom was up more than 2000%. Why? Because people messed up.
How does an efficient market not fix that?
Of course, there are other arguments against the efficient market hypothesis.
An irrational excitement might sweep the entire market, and an investment will be overpriced or underpriced, thus opening the door for a wise investor to move in and make legitimate money.
Many experts point towards cryptocurrency as an example of this “sweeping excitement.” The true value of cryptocurrency didn’t rise and fall by hundreds of percentage points over the course of one calendar year.
So why did the price rise and fall that much? How does EMH explain that?
Too complex = bad information
Another argument against EMH is that some investments are too complex for the market to grasp. If only 10 people in the world understand a particular investment, then how can the entire market evaluate it rationally?
The EMH assumption of “too many agents, too much competition” does not apply if only a tiny number of agents have a proper knowledge of the investment.
Some critics point towards individual events—e.g market crashes—as glaring evidence against EMH. If the market was all-knowing, why didn’t more people see the 2008 recession coming? Why weren’t there more “Big Short” people?
Countering the counter-points
The proponents of EMH have explanations for these examples. In short, EMH is concurrent with the explanation that some investments are “too complex.” This complexity explains the “bias” or the “market crash” outcomes.
Take cryptocurrency, for example. The value of cryptocurrency (according to a guy on YouTube) is based on complex mathematics and a deep understanding of how value is assigned to an asset. It’s graduate-level math and graduate level economics and graduate-level YouTube (Don’t forget to Like and Subscribe!).
It’s not an easy concept for most folks to understand.
When the cryptocurrency bubble expanded, it wasn’t based on widespread knowledge in a rational market. There weren’t thousands of knowledgeable investors saying, “I completely understand cryptocurrency technology, and I know why it’s undervalued.”
Instead, it was based on irrational excitement towards previous gains, and the fear of missing out on future profits. Fear and excitement are not rational.
On the Great Recession
Similarly, the market crash of 2008 was influenced by obscure and misunderstood investments in the housing market.
Subprime mortgages and collateral debt obligations were, according to EMH proponents, intentionally designed to be complex and difficult for most market agents to understand. Information about these housing investments was kept hidden, or the information that was made public was inaccurate.
In other words, the hallmark requirements of EMH—numerous knowledgeable agents and widespread information—did not apply to the 2008 Crash. And it was done that way intentionally.
Large investment firms believe in EMH so much that they are trying to manipulate the market (create complex investments, keep information private) in order to prevent the market from efficiently evaluating their investment vehicles.
By keeping information close to their chest, they believe they can fool the market and hoard the subsequent profits.
EMH makes a lot of sense if the market is an even playing field. But if the assets are too complex, EMH won’t apply. If the information about those assets is too far from the truth, EMH won’t apply.
Stock picking summaries
We covered why stock picking is hard, whether the market is “efficient,” and what we might do in response i.e. look into index funds.
At the end of the day, do what you will. But I’m avoiding dart-throwing monkeys. I’m not trying to out-compete all the other agents.
Average indexing is just right for me. It’s efficient.