Back to School

In Advice, Criticism, Financial on June 16, 2009 at 8:30 PM

Efficient Market Hypothesis (EMH). When our professors first introduced the concept to us in finance class, we were all blown away. Everything we knew about the stock market had been crumpled up and thrown into a waste basket in the span of an hour’s lecture. Although the idea lives primarily in classrooms, there’s no denying its power.

I noticed that instantly my classmates had either rejected the theory because it went against everything they knew and practiced, or they wholly embraced the idea like a new found religion. Nobody sat on the fence.

Wiki says: In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets (stocks, bonds, or property) already reflect all known information, and rapidly change to reflect new information. Therefore it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.

For example, as soon as RIM announces bad news, something like a product defect, the stock price drops before you can click on “sell” on your computer. By the time your order is processed you will have sold at a lower price, one that reflects the loss incurred by RIM. There are so many investors trading this stock around the world that that its price is perfectly efficient, given the information available at any point in time.

It doesn’t have to be company specific-information; it can be general economic news. For example, the stock price of a clothing store like the GAP can suffer from economic reports that state consumer spending is down and consumer confidence is low. It’s worked into the price by the time you hear the news. Retail stocks depend on consumer demand, the connection is real and the reaction is instant.

An extension of this theory is something called the Random Walk.

Wiki says: The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus the prices of the stock market cannot be predicted. It has been described as ‘jibing’ with the efficient market hypothesis. Economists have historically accepted the random walk hypothesis. They have run several tests and continue to believe that stock prices are completely random because of the efficiency of the market.

There is a myth that lives in finance textbooks about the Random Walk. We were told that in order to prove the theory, a scientist scattered some bird feed on the stock listings of the Wall Street Journal and allowed a pigeon to peck at the various stocks on the paper. Wouldn’t you know it? The pigeon’s portfolio provided a return equivalent to the overall market’s performance! The idea is that fund managers don’t have any distinct advantage over me, you, or the bird. In the long run, the fund managers that invest in equities simply earn the same overall rate of return that the market earns.

It was easy for me to embrace this theory. Entering the technology stock boom, at least a third of the people in my program were playing the market. These kids could not stop talking about their stock picks. They were buying low and selling high, or sometimes buying high and selling higher. They couldn’t lose. I didn’t understand how a bunch of bright-eyed pimple-ridden adults were beating the market. But once I learned about the EMH, things clicked. Anyone trading stocks during that time was profiting from a very positive market sentiment.

[An aside: One reason students could get in on the action was electronic trading and online brokerage services had become mainstream. Before online brokerages, you had to hire a broker and the commission costs were much larger, which was a barrier to younger inexperienced investors.

Another important note about that time was not only how misunderstood tech-stock valuations were, but there were some aggressive accounting policies that made many technology stocks look much more attractive. So you had good ideas being sold as profitable ideas, which wasn’t always the case, and on top of that you had company management aggressively recognizing revenues, both of which made several companies appear more profitable than they really were.]

What EMH and Random Walk are saying is that during a boom like that, everyone wins. And when the bubble bursts, everyone loses (including the pigeon). Of course that doesn’t change the money that was made and lost. It just illustrates that there is a general wave the stock market roller coaster rides, and whether you get stock advice from a pigeon, whether you read about the market and do your own analysis, or whether you invest in a mutual fund where a professional picks the stocks for you, ultimately, we’re all riding the same wave, and our returns will average out to be the same in the long run.

But you see, the real benefit of knowing these theories has nothing to do with making money. It has everything to do with how you look when you make money. It’s like when you fill out an NCAA bracket and you end up winning the office pool and then you tell everyone that your girlfriend made all the picks for you.

Of course, investing gets more complicated than that, especially when we start to look at what hedge funds can do. But for people like you and me, and the pensions and mutual funds that invest on our behalf, the EMH simply serves as a reminder that you win some and you lose some. But most importantly, it assures us that there is no secret way to beat a pigeon at investing.


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