Recently, there has been a trend in stock investment which recommends passive investing. This involves putting money away in index funds to gain exposure to the entire market, rather than picking individual stocks. As a passive investor you aim to largely keep your fees low, minimize portfolio turnover and benefit from secular growth trends over time. But is this really the best strategy for you as an investor? Enter the Efficient Market Hypothesis (EMH) The EMH suggests the stock market is efficient. The EMH suggests that existing share prices incorporate and reflect all relevant information in stock prices,…
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Recently, there has been a trend in stock investment which recommends passive investing. This involves putting money away in index funds to gain exposure to the entire market, rather than picking individual stocks. As a passive investor you aim to largely keep your fees low, minimize portfolio turnover and benefit from secular growth trends over time. But is this really the best strategy for you as an investor?
Enter the Efficient Market Hypothesis (EMH)
The EMH suggests the stock market is efficient. The EMH suggests that existing share prices incorporate and reflect all relevant information in stock prices, making it very difficult to pick individual investments. There are three different forms of the EMH that are largely discussed in academic circles.
- Strong-form EMH: This theory suggests that stocks are always fairly valued and a it is impossible to buy undervalued stocks without being lucky. This theory also suggests that it is impossible to time the market and that future returns cannot be predicted in any way by looking at past performance.
- Semi-Strong EMH form: This theory suggests that the price of a stock incorporates all public information and as new information becomes publicly available, the marketing instantly reacts and prices in the stock market adjust accordingly. Investors therefore cannot beat the market without having access to more information.
- Weak-EMH form: This suggests that all public information may or may not be available to investors and not all variables are incorporated into the price, rather only historical price is available. This argues that technical analysis or studying graphs of stock prices is completely useless.
Are markets really efficient?
George Soros developed the conceptual framework of reflexivity to explain why markets are not efficient. The core principals of the theory are:
- Objectivity: These are facts which are true regardless of what the market thinks.
- Subjectivity: These are subjective realities which are affected by what people think about them.
George Soros argues that since perfect information is not available, it is impossible to determine what causes movements in stock valuation. To Soros collective thinking means that reality affects reality itself (i.e. people invest into a company which is making little money because they believe in its prospects and are reassured by others who believe in its prospects, creating a group-think).
Soros believes that opportunity is created when the market prices a distorted view of reality which allows the rational investor to take a contrarian stance and profit from fundamental errors in valuation.
Berkshire Hathaway & Efficient Markets
Founded by legendary investors Warren Buffett and Charlie Munger, Berkshire Hathaway (1962) has achieved a 1,826,163% increase in stock price, majorly outperforming the stock market. It is difficult to believe that if markets were perfectly efficient such a return would be possible. Clearly, neither Buffett nor his partner Charlie Munger believes in the theory.
In fact, Berkshire Hathaway demonstrates that markets are generally much less efficient than most people think.
What this means for you as an Individual Investor
For the individual investor passive investing is a great way to invest, without having to actually put in any work! It’s clear that over time you will be able to achieve a moderate return on your investment and plan for your retirement.
However, if you believe that you are skilled enough to value individual companies, it is clear that the EMH is false. The experience of investors such as Warren Buffett, George Soros and Charlie Munger has shown that it is possible to become extremely rich identifying market inefficiencies. However, remember that this requires putting in a lot of work and a tremendous skill-set. For you as an individual investor, you should decide which approach works best for you, based on your individual circumstances.
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Motley Fool contributor Marcello Pinto has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.