Where did the efficient market hypothesis come from? Three financial asset investing approaches are Modern Portfolio Theory, Technical Analysis, and Fundamental Analysis. Modern Portfolio Theory assumes that markets are efficient. Others believe they are not. A considerable debate is whether the markets are efficient or not. I think it would be good for an investor to have an idea of the content of this discussion. I dealt with Modern Portfolio Theory in a separate article. First, let’s briefly answer the question of what Technical Analysis and Fundamental Analysis are.
Technical analysis is essentially a method of predicting which direction asset prices will go by examining historical market data such as price and volume. According to the technical analysis, prices contain all factors affecting the market. Therefore, analyzing the price data is sufficient for investment. Its history goes back to the 17th-century Dutch financial markets. The development of modern technical analysis is based on the Dow Theory of Charles Henry Dow. He is co-founder and editor of the Dow Jones company, published on Wall Street at the end of the 19th century. Dow has tried to predict the direction prices will go by examining market trends. Today, traders use different technical analysis methods. I did a bit of technical analysis to satisfy my curiosity and learn for a while.
Fundamental analysis is an investment philosophy based on estimating the intrinsic value of a financial asset by examining all economic factors. For instance, the firm’s business model, profitability, cash flow, investments, competitiveness, quality of business management, etc., examine the criteria. In this respect, fundamental analysis contrasts with technical analysis. They decide whether it is cheap or expensive by comparing the share value they have obtained due to this examination with the market price. According to fundamental analysis, the asset’s current market price does not accurately reflect the investment’s intrinsic value. However, in the long run,’ the market will reflect the asset’s actual value in its price. Therefore, in this sense, it contradicts the efficient market hypothesis, as we will see below. Value investors include Benjamin Graham, Warren Buffet, and his partner Charles Munger.
What is the efficient market hypothesis?
University of Chicago finance professor Eugene Fama defined market efficiency as the price reflecting all the information in that information set. Princeton University economics professor Burton G. Malkiel is one of the defenders of the hypothesis. Similarly, he states that the market will be efficient if the price is not affected when the information set is presented to all market players. In other words, the efficient market hypothesis states that asset prices contain all available information.
Suppose that new information, such as a merger that affects the value of a share, is presented to investors. Suppose the stock price does not reflect this further information. In that case, investors in the market will buy and sell that stock to take advantage of this profit opportunity. Therefore, the prices formed in the market are always fair, reflecting the intrinsic value of the assets. The efficient market hypothesis goes back to the early 20th-century doctoral thesis of a French mathematician, Louis Bachelier. Curious about the more detailed historical background of the idea, have a look at this study.
What does the efficient market hypothesis mean?
Picking cheap stocks or timing the market is pointless if the efficient market hypothesis is true. In other words, this hypothesis implies that it is impossible to consistently beat the market, that is, to earn returns well above the market average – except by taking more risks. Because market prices only react to new information. Modern Portfolio Theory says that if you want to earn more returns, you must take more systematic risks. You can take more risks and consistently get returns above the market average. This does not contradict the efficient market hypothesis.
Random walk hypothesis
The random walk hypothesis is closely related to the efficient market hypothesis. According to this hypothesis, changes in stock prices are entirely random and unpredictable. Burton G. Malkiel, an economics professor at Princeton University, popularized the random walk hypothesis in his book ‘A Random Walk Down Wall Street‘ in 1973. In a test that Malkiel had his students take, the starting price of a fictitious stock was $50. At the end of each day, the closing price will be determined by flipping a coin. The closing price will be 0.5 dollars above if it gets heads and 0.5 dollars below if it gets tails. Therefore, there is a 50% chance that the next day’s price will be above/below the previous day’s closing price.
After he had his students done this practice enough, he plotted the prices formed on a chart. Then he asked a technical analyst to interpret the chart in question, assuming that the past was constantly repeating itself. Pointing to the rising trend, the analyst advised Malkiel to buy this stock immediately. However, there is no trend. The stochastic process determines the price of our fictitious stock. That is the price is determined by flipping a coin!
Wall Street Journal’s contest
In his famous book, Malkiel claimed that the performance of a portfolio that a blindfolded monkey will create by throwing darts at the share prices page of a financial newspaper will be at least as good as the performance of a portfolio that will consist of stocks that will be carefully selected by experts. In 1988, the Wall Street Journal contested whether Malkiel’s claim was valid. The newspaper employees took on the role of a monkey. They created a portfolio by throwing darts at a table of stocks. Experts, on the other hand, made their portfolios as they wished. After 6 months, the performance of the portfolios was compared. Until 1998, this competition was repeated 100 times.
The result of the competition
According to the results announced by the newspaper, 61 of the 100 competitions were won by experts and 39 by ‘monkeys.’ Experts’ performance against the Dow Jones Industrial Average index was much worse. They could surpass the performance of the Dow Jones index only 51 times. It should be underlined that in these competitions, issues such as transaction costs and taxes are not considered. You can say it’s not wrong to win 61 times. But Malkiel disagrees. Malkiel pointed out that the experts deliberately chose riskier stocks to win the race and that while the performance of the portfolios created by throwing darts after the 6-month period was over, the performance of the experts decreased.
Criticisms of the efficient market hypothesis
This hypothesis, which significantly impacted modern finance theory, naturally received many criticisms. Criticism comes from the academic world of finance and value investors like Warren Buffet. Empirical studies have not yielded conclusive results confirming or rejecting the efficient market hypothesis. While there are studies that support the idea, there are studies that do not.
According to behavioral economists
Let me state that there is a section that sees the work of behavioral economists as an alternative to the efficient market hypothesis. Behavioral economists point to human cognitive biases, such as overconfidence or overreaction, as the cause of disturbances in financial markets. On the other hand, Daniel Kahneman, one of the founders of behavioral economics, expressed his doubt that investors could beat the market.
Many of you know that Warren Buffet is a famous investor with returns well above the market average for many years. In this sense, Warren Buffet’s return performance is cited as an example that contradicts the efficient market hypothesis. Because, according to the proponents of the efficient market hypothesis, searching for cheap stocks in the market or predicting market trends with technical or fundamental analysis is meaningless. Another economist, Paul Samuelson, argued that stock markets are efficient in the micro sense but not in the macro definition. On the other hand, based on some empirical findings, Robert J. Shiller argued that long-term investors can outperform by buying when the market is falling and selling when the market is rising. For more detailed information on reviews, see here.
What does the efficient market hypothesis mean for investors in practice?
Best investment strategy
If the efficient market hypothesis is correct, the best investment strategy for investors is to create a low-cost, passively managed portfolio. That is, investing in funds and ETFs that mimic the low-cost index. The difference in cost items such as the funds’ management fees determines the performance in the long run. The rest is luck. In fact, Morningstar company found in a study that actively managed funds systematically outperform passively managed funds (from index-tracking funds and ETFs) except in some areas. The exceptions were US small company growth funds and diversified developing country funds.
Automation of investment
We can also talk about the robot consultant (Robo-advisor). The robot consultant, or computer software, manages all your investments, optimizes taxes, and even plans for retirement for a low fee. The system works by combining Modern Portfolio Theory and passive index strategies. Betterment, the first robot consulting company, was founded in 2008 and started accepting money from investors in 2010. As of mid-2019, the fund size managed by robot advisors is estimated to reach $440 billion. The financial world has high expectations of this technology.
In terms of financial independence
My personal opinion is that the markets are partially efficient. I don’t think it is possible to predict the direction the stock prices will go, especially in the short term. On the other hand, it may be possible to take a position by predicting market fluctuations in the medium and long term. This strategy can work exceptionally well in developing countries that experience a constant cycle of challenging ups and downs. I plan to manage my portfolio in Borsa Istanbul by considering the medium term (3-5 years).
Focus on savings
It doesn’t matter whether the efficient market hypothesis is correct regarding financial independence. Because the variable that most affects our time to reach financial freedom is the savings rate, not the rate of return. Therefore, spending our limited time thinking about increasing our income and saving rate is more beneficial. Beating the markets will remain a dream for most investors. Just as we cannot paint and sculpt like Leonardo Da Vinci, we cannot be value investors like Warren Buffet. Moreover, even Warren Buffet willed to invest 90% of his inheritance in a fund that tracks the S&P 500 index.
As a result, even if the efficient market hypothesis is not valid, I think the best financial independence strategy is to use passive index investing by achieving a high savings rate.
So what do you think about this? Do you think you can beat the S&P 500 by picking stocks consistently?
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