In simple terms, the efficient market hypothesis says that there is no better measure of the value of a stock than its market price. In his 1988 letter to shareholders , Warren Buffett ridiculed academics who cling to efficient market theory in the face of decades of market beating returns by Buffett and his mentors, saying “apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.” This debate rages on with one side insisting markets are efficient or nearly so, and the other side dismissing efficient market theory. However, this debate is mostly pointless. On its own, it makes little sense for the stock market to be efficient or not. It can only be efficient with respect to some observer. This means that the market can appear to be efficient to one investor, but not another. To explain what I mean by market efficiency being dependent on the observer, consider a simple example of a coin toss. To most observers, when the coin re...

In a previous post I explained how it is possible for superior investors to beat market averages by focusing on long-term value instead of short-term stock prices. This is the exception to efficient market theory. This can make it tempting to become a stock picker. Confidence can be dangerous. Before you jump in believing that you can beat the stock market average, understand that most people who try to do this will fail. It’s not possible for most people to be above average. Add to this the trading costs and volatility that come with individual stock picking, and most stock pickers will make less than the stock market index. Another problem is that it takes a very long time to tell if you have a talent for judging to true value of companies. An investor could just be lucky for 10 years and then suffer disastrous losses because he really doesn’t know what he is doing. By the time you have invested long enough to know whether you are a good stock picker, much of your investing life...

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 yo...