The idea of an efficient market can easily be summed up in a short story:
A student walks around campus with a professor and comes across a $100 bill laying on the ground. Just as the student stops to pick it up, the professor says, Don’t bother. If it was really a $100 bill, it wouldn’t lay there.
The efficient market hypothesis was put forth by Eugene Fama in the 1960s. It postulated that stock prices reflect all available information and trade at exactly their fair value at all times. If there really was a $100 bill, someone would’ve already picked it up. The direct implication is that the risk you take is linear with the returns you can make, making it impossible to beat the market on a risk-adjusted basis.
It was a powerful concept that gained a lot of traction, especially within academic circles. That, of course, wasn’t a bad thing because it pushed a lot of ordinary investors to put their money into index funds and stop trading around all the time.
But the hypothesis entailed a flaw. For a market to be efficient, there must be trading and active research. And why would anyone do either if prices perfectly reflected available information at all times? If no one did any active research, the market cannot be efficient. This is called the Grossman-Stiglitz paradox. Warren Buffett described it well when he said, what could be more advantageous than to deal with a trading partner who was trained not to think?
Knowing the points for or against the hypothesis makes it easy to either fully absorb the idea or completely dismiss it. That’s what a lot of academics, investors, and other practitioners have done for decades since the hypothesis started a revolution in finance. Besides modern portfolio theory, probably no other topic in finance has divided the camps as much as the efficient market hypothesis.
But I suggest being a little careful with jumping into either camp. Indeed, the average Joe investor would actually be better off leaning toward the “believer” camp, investing their life savings in a broad market index fund instead of jumping in and out of the market in an attempt to capitalize on its “inefficiency”. Because even though we can be pretty sure that the idea of perfect market efficiency is folly, the reality is that the efficient market hypothesis is roughly right. It’s very hard for anybody to beat the market by any significant margin by just being an intelligent stock picker. The iron rule of life is that only 20% of the people can be in the top fifth.
When you trade in the market, you may not compete against a know-it-all machine, self-correcting itself at lightning speed with no chance of a fight. But you do compete against millions of real people on the other side of every transaction you make. These people may be better educated than you, have more money than you, have more power than you, and have more experience than you. And then there’s some truth to the wisdom of crowds—that collectively, large groups of people are smarter than individual experts. To beat the market and make active research worthwhile, you will have to make better decisions than all of these people. You will have to be right, and they will have to be wrong.
Now some good news. Because the market is partly efficient, you can expect to make money off your disciplined efforts. If it wasn’t so, you could never expect the value you find to ever come to you. The fact that the market is partly efficient is really a gift when you know what you are doing.
So, this is how you use the efficient market hypothesis to your advantage, whether you believe in it or not. Because the market is partly efficient, you can always know that:
- It’s hard to find value where lots of others are looking.
- When something looks too good to be true, it probably is.
- You can only expect to do well if you bet seldom.
- If you’re right, the market will agree with you at some point.
It doesn’t really matter whether you believe the market is efficient or not. Because it’s both. What matters is whether you can find opportunities in the market—buying securities for less than their intrinsic worth—and whether you are confident in your own ability in finding these mispricings. The answers to these questions solve your problem.
To gauge the market’s efficiency, look at how many obvious value opportunities there are to find, how many times you must cast your fishing rod to find them, and how big the margin of safety is. When you rarely find opportunities, the market may be very efficient. That happens from time to time because the market’s efficiency ebbs and flows.
The solution is simply to practice patience with your fishing rod firmly in hand, willing to pull hard when the occasional catch comes along.
