I have a fairly obsessive personality. When I first started investing, I read everything I could find on the topic (I guess I still do). One of those books was A Random Walk Down Wall Street by Burton Malkiel. In the book, Malkiel (a Princeton econ professor) makes a very convincing argument that markets are efficient, random and virtually impossible for anyone to beat consistently. He demonstrates that randomly picking stocks will keep up with the returns of many professional investors. The random walk theory is very similar to the efficient market hypothesis.
The efficient market hypothesis basically states that stocks reflect all the information available. The random walk theory basically states that stock prices have no memory, and that any historical price data is already built into the current price. The theories are closely related. According to these theories, anyone beating the market consistently is highly unlikely. Anyone who does so would be considered an anomaly, or in statistics speak – an outlier.
If you’ve read this book, you can’t help but be struck by the logic. The numbers are hard to argue with. It’s extremely difficult to pick a manager that will beat the market with any consistency, and if you can’t count on professional investors to do it, how can you expect to do it yourself? Then I read The Intelligent Investor and Security Analysis by Ben Graham, The Essays of Warren Buffett, Beating the Street by Peter Lynch, and a host of other books with a value slant. Value investing depends on taking advantage of the very market mispricings that the efficient market hypothesis claims doesn’t exist. Interestingly, the people that do beat the market consistently seem to fall in the value investing group.
Buffett repeatedly denounces the efficient market hypothesis in his speeches and letters. He is, after all, THE most prevalent outlier. Buffett has loudly trumpeted the value of fundamental analysis for years on end. The logic of his method is difficult to argue with. Ben Graham was famous for investing in stocks now referred to as “net-net” stocks. A net-net is a stock selling below the reproduction value of its assets – cash, receivables, and inventory – after all liabilities have been paid. In markets where such investing opportunities exist, how can anyone claim that markets are efficient? Of course, once enough investors identify a particular stock as a net-net, investment in the stock will raise the price until it no longer qualifies as one. Graham found many net-nets in his day. Value investors identify market inefficiencies. Certain groups of stocks, such as spinoffs, tend to beat the market by a fairly large amount (see this post for more on spun off securities).
My take
The true value investors (Buffett, Seth Klarman, Michael Price, etc.) are worth betting on as having a great chance of beating the market. Proponents of the efficient market hypothesis tout index funds as great investments. I can’t disagree with that. Since you don’t have any certainty that someone will beat the market over any period of time, index funds mirror the returns of the overall market while keeping your costs very low. Both my wife and I have all of our retirement accounts in various index funds. In our taxable accounts, however, we hold some individual securities. I do think it’s possible to pick individual issues that have the potential to give above average market returns. I don’t believe that markets are always efficient. I do, however, think it’s important to keep in mind that markets are efficient most of the time. If they were always efficient, not only would stocks not be underpriced, bubbles would never form, either. We wouldn’t have inflated prices to crash from. My personal opinion about the current state of the market is that all the bad information is pretty much priced in, and that extra bad info pushes the market down further while mostly disregarding the fundamentals. I can’t predict where the market will go over, well, any period of time, but the market has been creating long term wealth for quite awhile now. I personally don’t think stock picking is dead…yet. Feel free to share your take on the efficient market hypothesis by email or in the comments. Thanks for reading.
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#1 by the weakonomist on March 9th, 2009 - 5:35 am
In the long-term I believe the market is effecient, which is why I don’t waste time trading stocks. I too was convinced by the Random Walk theory.
People like Buffett though are able to buy long-term investment they believe in because they’ve met the management and employees of the company. This is just as important as looking at an income statement, and it’s not something most of us can do. Good post.
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Todd Reply:
March 9th, 2009 at 8:16 am
While I agree that having access to management gives you an advantage, I think there’s more to it than that. Most large portfolio managers can gain access to employees. It definitely is an advantage pros have over amateurs though. Another advantage lies in the fact that Buffett often buys entire companies. Special situations often lead to mispricing. Small cap stocks are more often mispriced due to fewer analysts following them. I agree that it is very difficult for non-professional investors to spot these situations and profit from them. I don’t think it’s impossible, though. Thanks for commenting.
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