The idea of an efficient market can be summed up in a short story:
A student walks around campus with a professor and comes across a $100 bill on the ground. Just as the student stops to pick it up, the professor says, “Don’t bother—if it was a $100 bill, it wouldn’t lay there.”
The efficient market hypothesis was put forth by Eugene Fama in the 1960s. It postulated that stock prices reflect all available information and trade at their fair value at all times. If there really was a $100 bill, someone would’ve already picked it up. The direct implication is that the risk you take is linear with the returns you can make, making it impossible to beat the market on a risk-adjusted basis.
The concept gained lots of traction, especially within academic circles. That, of course, wasn’t a bad thing because it pushed lots of ordinary investors into index funds, significantly reducing their trading activity.
But the hypothesis had a flaw. For a market to be efficient, there must be trading and active research. And why would anyone do either if prices perfectly reflect available information at all times? If no one did any active research, the market can’t be efficient. This is called the Grossman-Stiglitz paradox. Warren Buffett has said, “what could be more advantageous than to deal with a trading partner who was trained not to think?”
Knowing the points for or against the hypothesis makes it easy to either fully absorb the idea or completely dismiss it. That’s what many academics, investors, and other practitioners have done for decades since the hypothesis started a revolution in finance. Besides modern portfolio theory, few other topics in finance have divided the camps as much as the efficient market hypothesis.
But I suggest being careful with jumping into either camp. Indeed, the average Joe would be better off leaning toward the “believer” camp, investing their life savings in a broad market index fund instead of jumping in and out of the market in an attempt to capitalize on its “inefficiency”. Even though you can be sure the idea of perfect market efficiency is folly, the reality is that it’s roughly right. It’s hard for anybody to beat the market by any margin by just being an intelligent stock picker. The iron rule of life is that only 20% of the people can be in the top 20%.
When you trade in the market, you may not compete against an all-knowing machine, self-correcting itself at lightning speed with no chance of a fight. But you do compete against millions of real people on the other side of every transaction. These people may be better educated than you, have more money than you, have more power than you, and have more experience than you. Then there’s truth to the wisdom of crowds: collectively, large groups of people are smarter than individual experts. To beat the market and make active research worthwhile, you’ll have to make better decisions than all of these people. You will have to be right, and they will have to be wrong.
Now some good news: because the market is partly efficient, you can expect to make money off your disciplined efforts. If that wasn’t the case, you could never expect the value you find to ever come to you. The fact that the market is partly efficient is a gift when you know what you’re doing.
Because the market is partly efficient, you’ll always know that:
- It’s hard to find value where others are looking.
- When something looks too good to be true, it probably is.
- You can only expect to do well if you bet seldom.
- If you’re right, the market will agree with you at some point.
It doesn’t matter whether you believe the market is efficient or not. Because it’s both. What matters is whether you can find opportunities—buying securities for less than their worth—and whether you’re confident in your ability to find these mispricings. When you rarely find opportunities, the market may be efficient at that point in time. That happens occassionaly because the market’s efficiency ebbs and flows. The solution is to practice patience with your fishing rod firmly in hand, willing to pull hard when the occasional catch comes along.