Tuesday, April 8, 2008

Efficient Market Theory

According to proponents of efficient market theory, it isn’t possible to do better than market averages by picking your own investments. New information gets incorporated into stock prices almost immediately making it impossible to profit from this information.

On the other hand, there are a handful of people like Warren Buffett who have outperformed stock market averages for so long that it couldn’t possibly be a fluke.

Both sides in this argument make a strong case. But who is right? As usual, the answer is somewhere in between.

Price vs. Value

At any given moment, the price of a stock is determined by the crowd of people making bids to buy and sell shares. If some good news comes out, the stock’s price will shift upward due to the change in bids coming from the crowd.

The crowd isn’t necessarily right, though. A stock’s true value, which is based on the company’s future prospects, could be $20 even though the crowd sets a price of $10. But this doesn’t necessarily mean that you will make an instant profit by buying the stock at $10. The crowd might continue to undervalue the stock for a long time.

At the other extreme, we have bubbles (like the high-tech bubble and the recent housing bubble) where prices rise unreasonably high and stay there for a long time.

You can only profit from changes in a stock’s price. By buying a stock worth $20 for $10 you are hoping that the crowd will eventually see the real value and increase the price. This is usually a better bet than buying stocks worth only $5 at a price of $10, but there are no guarantees.

How do Superior Investors Succeed?

Superior investors are better than the crowd at assessing a stock’s true value. They buy stocks for less than their true value and wait. This strategy doesn’t work out every time, but it succeeds often enough to give these investors above average returns.

Does this mean that efficient market theory is wrong? Not exactly. If you examine most of the arguments made in support of this theory, the focus is short-term. Short-term trading success has nothing to do with the true value of a stock. The only way to make money in the short term is to predict changes in the price set by the crowd.

Short term trading is about trying to outguess the crowd about how stock prices will change. Without inside information, I can’t see how this is possible given the speed at which new information flows to all investors.

Efficient market theory says that you can’t reliably predict what the crowd will think faster than the crowd thinks it. This makes sense to me.

Which side is correct?

For short-term traders, efficient market theory is essentially correct. I’ve never seen any evidence that anyone can reliably make money with short-term trading without using inside information. For long-term investors, it seems that some investors are capable of judging a stock’s value better than the crowd.


  1. Buffet might be the only example of someone who beats the market for a crazy long time.

    As much as I admire him, he isn't really a normal investor or even a normal fund manager since he has a lot better access to companies than anyone else.


  2. Four Pillars:

    I agree that there don't seem to be any others like Buffett. But, he has outperformed by a very wide margin for a very long time. There could be many other people who have outperformed by smaller margins.

    Buffett has a level of access now that we can't match, but I'm not sure that this was as true back when he was making his best returns.

    In any case, I think it's best for most of us to proceed assuming that we can't outperform the market.

  3. I currently seem to be singlehandedly defending the efficient-market hypothesis here. Thought you might be interested.