- I believe that academic research and empirical evidence
create the best path to a sensible investment philosophy
and to sensible decisions in general.
The academic and empirical understanding
of financial markets
starts with the efficient market hypothesis.
An efficient market is a market in which asset prices
always fully reflect available information.
The implications of market efficiency
for investors are sweeping.
If asset prices always fully reflect available information
there is only one way to profit,
by taking a risk that has been priced into the market,
which can be done cheaply with an index fund.
If the market is not efficient
then it should be possible to profit
by consistently selecting undervalued stocks
and timing the market.
I'm Ben Felix, portfolio manager at PWL Capital.
In this episode of Common Sense Investing
I'm going to tell you
why you should treat the market as efficient,
even if it isn't.
In an efficient market, active management,
the process of selecting stocks and timing the market
is not able to consistently add value
and index funds are the most sensible approach to investing.
This highlights the importance
of market efficiency to any investor.
If you believe that you can exploit market inefficiencies
you will take a dramatically different approach to investing
than if you believe that markets are efficient.
In an efficient market,
there is no such thing as undervalued or overvalued.
Prices are simply reflections of information
and expectations at a point in time.
The only way that prices will change
is based on new information,
which by nature of new information, should it be random.
This random movement of prices
renders the prediction based security selection
and market timing that constitute traditional
active management completely useless.
We cannot predict randomness.
Some of the earliest tests of market efficiency
conducted in the 1950s examined stock returns
to see if they followed identifiable patterns
or if they were random.
Before this research had been done,
the assumption of economists was that trends and patterns
were present in stock returns.
In 1953, Maurice Kendall used early computing power
to examine time series of stock returns.
His conclusion surprised everyone at the time.
He concluded that, quote, "In the series of prices
which are observed at fairly close intervals,
the random changes from one term to the next are so large
as to swamp any systematic effect which may be present.
The data behave almost like wondering series."
In other words, there were no patterns,
the stock returns that were observed to be random.
Tests for market efficiency
have become more robust over time.
But before we get into that evidence,
I think that we need to cover the economic reasons
that markets should be efficient in the first place.
Financial markets are highly competitive.
Buyers and sellers of securities are competing
to execute trades at the best possible price
for their own self interest.
Financial markets are also liquid.
In a competitive and liquid market
with lots of independent buyers and sellers,
we would expect buyers,
based on their information and preferences
to buy securities that they deemed to be worth more
than what they paid for them.
On the other side of the trade
we expect the seller to believe
that the cash that they receive
from selling the security is worth more
than the securities that they sold.
As an aside, this is always a good question to ask yourself
before you buy or sell a stock,
who is on the other side of the trade,
what information do you have that they don't?
Anyway, buyers and sellers ultimately converge on the price
to execute a trade.
This competition between self interested and opposite views,
buyers and sellers, in liquid markets
is what makes prices reflect the expectations
of all market participants.
The price becomes a mechanism
to aggregate disperse bits of information
about fundamental values and expectations
from all market participants.
Every market participant wants to be the one to profit
by bringing new information to the market.
The challenge is that any market participant
with new information is unable to interact
with the market in isolation.
They cannot know about all of the new information
that other market participants
may be bringing to the market at the same time.
And even beyond that,
they do not know how other market participants
are going to interpret their new information.
The result of this interaction
is a market that reflects information in prices,
while also making it extremely challenging
for anyone to profit consistently
by identifying and trading on new information.
Now let's take a deeper look at the evidence
of market efficiency.
It should be noted at this point that Eugene Fama himself,
the man credited with formalizing the idea
of market efficiency,
has never claimed that markets are perfectly efficient.
Market efficiency is an ideal state
that real markets can only approach.
Understanding that we do not expect
a perfectly efficient market,
the big question is whether inefficiencies
can be consistently exploited to products after costs.
As investors, this is all that matters.
The efficient market hypothesis is not a law or a fact,
it is a hypothesis.
What do we do with a hypothesis? We test it.
The most and robust approach to testing market efficiency
is the study of fund managers ability to beat the market
without taking on additional risk.
Excess risk adjusted returns, known as Alpha,
are the ultimate goal of an active manager.
Keep in mind in a perfectly efficient market,
the only way to consistently generate higher returns
is by taking more risk.
An active manager or some other strategy
consistently generating above market returns,
without taking additional risk,
would violate market efficiency.
Whether markets are perfectly efficient or not,
the question that we as investors have to ask
is whether market inefficiencies
can occur predictably enough
to be exploited by us after costs
and considering the risks associated
with attempting to do so.
In strict scientific terms,
the efficient market hypothesis is false.
But in practice, it is true enough to be treated as true.
In terms of understanding and approaching financial markets,
the efficient market hypothesis is, by far,
the strongest hypothesis that we have.
Do you think the market is more efficient or inefficient?
Tell me why in the comments.
Thanks for watching.
My name is Ben Felix of PWL Capital
and this is Common Sense Investing.
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who you think could benefit from the information.
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(upbeat music)