Active vs Passive: Why the Efficient Market Hypothesis is Wrong
There has been an explosion in passive investing strategies over the last ten years. Firms like Blackrock and Vanguard have grown into behemoths, managing trillions of dollars largely on the back of offering very cheap access to markets. For a tiny fee, you can buy a fund that replicates the performance of the S&P 500 index, or really any other index you should choose.
Passive strategies rest on one main belief- that markets are ‘efficient’, and therefore cannot be beaten. If markets can’t be beaten, the best way to invest is as cheaply as possible- hence passive. The Efficient Market Hypothesis (EMH) says that every share price reflects all publicly available information. I.e.: the market prices stocks (and indeed all assets) accurately and correctly.
The logic goes that investors have access to the same information and the share price is therefore the aggregate representation of intelligent assessment by hundreds of thousands of market participants. In other words, there is all this financial data out there, stock earnings, financials, interviews with management, etc, and there are all these smart investors looking at that data, dissecting it, parsing it, and deciding what it means for the future of the stock. On average, all those smart investors get it right, causing stocks to be fairly-valued. If all stocks are fairly-valued, it follows that there can be no cheap or expensive stocks, and therefore no way to make money from actively trading them. Therefore, there is no point in paying a fee to an active manager.
Under this belief, an investor cannot consistently pick a group of stocks that do better than the S&P 500 or some other relevant average except for by luck, or by cheating (which is typically the use of insider information).
The problem is, this theory is clearly flawed, and in fact has been proven so for many decades, by many investors who have consistently outperformed the market- people such as Warren Buffett, Howard Marks, Joel Greenblatt, Seth Klarman, Peter Lynch, Bill Ackman, and so on.
The Case for the Efficient Market Hypothesis
Before we lay out the arguments against the EMH, it is important to note that just because no market is completely efficient, it doesn’t mean that some markets aren’t more efficient than others. To conceptualize this, consider the difference between investing in a private real estate deal, and investing in large public markets like stocks and bonds.
In the private real estate deal, the information gap between the buyer and the seller could be huge. One side might have unique information about the property or neighborhood- but in the public markets, no one really has this unique information and if they do, it is called insider trading and they go to jail for it.
In theory, in the public stock market, a teenager with a laptop has the same access to information as the head of research at Goldman Sachs. The internet has added this level playing field. In this sense, the public markets are more efficient than the private markets, but they are still a long way away from being completely efficient.
Why Markets are not Efficient
There are three main points to make here:
1) Markets are driven by humans. Humans are not rational, nor efficient. The Efficient market hypothesis relies upon market participants (people) acting rationally and responding to news flow and information in a logical manner. We know neither of these things are true. Humans have an innate, permanent nature to them that makes them act emotionally, irrationally, and herd-like. We have seen many examples historically of wild asset mispricing driven either by fear or by greed, and we will continue to see many more in the future.
Remember the dot-com craze at the end of the 1990s (and the subsequent crash) when all you needed to do was put dot-com behind a company name and almost everyone would jump in to buy it. Internet companies were trading at up to 100x revenue. Most of these companies had never generated a single dollar of profit, and many did not even have a plan for how to do so in the future. Those excessive valuations were not efficient nor representative of the publicly available information at the time, nor rational. Only a few months later and the market was mispricing on the downside- with many longstanding, profitable companies trading at cents on the dollar, having been dragged down by excessive investor pessimism.
More recently, we have seen similar irrational exuberance and significant mispricing in Bitcoin. You might remember there was an interesting mishmash of FOMO (‘fear of missing out’), storytelling, wishful thinking, speculation, confirmation bias, and technological jargon coalescing around the idea of Bitcoin as an ‘investment’. To display the absurdity of stock prices, a company named Long Island Iced Tea’s stock rallied 500% after it changed its name to Long Blockchain. The company was doing the exact same thing that it was doing before, but now it had blockchain in its name. That is not a rational or efficient market response.
Similar examples of excess greed followed by excessive fear are littered throughout history. As long as markets consist of humans, the same will be true of the future. The market will continue to be emotional and offer wildly different prices depending on the day of the week.
2) The argument that investors can’t beat the market is tautological and mostly useless. What the EMH advocates are really saying is that the average investor can’t beat the market, but the market is simply the average decisions of all investors taken together. In other words, the average investor and the market are synonyms for each other. So, they’re saying that the average investor cannot beat the average investor, or the market cannot beat the market. Which is true, but not really useful.
3) Many investors have indeed consistently beaten the market. This point was made by Warren Buffett thirty years ago when he gave a speech at the Columbia School for Business succinctly refuting the EMH. At the time, the influential EMH academics had heard of Mr. Buffett’s track record and explained it away as a simple coin-flipping game, where with enough coin flippers, someone’s bound to enjoy a long winning streak.
Mr. Buffett ran with this analogy, explaining that if we imagine a national coin-flipping competition with all 225 million Americans, where every morning the participants would call out heads or tails and if they’re wrong, they would drop out. After twenty days, 215 coin-flippers would remain. A one in a million outcome for each individual flipper, but an expected result for the whole. But what if all the remaining coin flippers happened to come from say the same school in Omaha? What were the chances of that?
Buffett argued that “Graham-and-Doddsville” was just that place, and that exact scenario had played out in reality. He presented nine different funds that beat the market averages over long periods, all sharing a single quality: a consistent, active investment strategy. They didn’t buy the same securities, but they did follow the same philosophy.
Since the day of that speech, Berkshire Hathaway’s book value has grown 18% annualized, beating the S&P 500 by 7.4% annualized, with lower volatility.
It is therefore fundamentally clear that markets are not perfectly efficient. As a result, the thoughtful and prudent active investor can expect to be able to outperform the market over the long term. The next logical question is therefore: how can one do this?
This is where a focused and fundamental investment philosophy and strategy are essential. We recognize that there is a difference between the price a business trades for on the stock market and the genuine intrinsic value of that business. The key is identifying what that intrinsic value is. Once we have established that, it is easy to determine which shares are underpriced and which are overpriced. To be able to understand the intrinsic value of any business requires many hours of research and due diligence. For the current mispricing to correct within the market may also require patience- as in some cases it can be a long period of time before the underlying economic performance of a company is recognized amongst the emotional gyrations in the market.
It is therefore important that we recognize a fundamental difference in mindset- we do not look to the market for verification of a company’s value. We look to the market as an opportunity to buy or sell shares in a company. The share price itself is not an indication of what that business is actually worth. As Benjamin Graham, Warren Buffett’s mentor, once wrote, “The market is there to serve you, not to guide you.”
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