The efficiency of communication has progressed as follows: horseback, slow boat, smoke signals, homing pigeons, flashing lights on navy ships, Morse code, telegraphs, telephones, radios, televisions, computer networks, and finally the Internet. With each step, information and news became cheaper, more accurate, and more rapidly disseminated.
The Efficient Market Hypothesis simply states that market prices accurately reflect all available information at all times. This leads to the conclusion that it is impossible to consistently beat the market averages. As Bachelier stated in 1900, the expected return of speculation is zero. The most recent studies by Richard Roll indicate that new information is reflected in market prices within five to sixty minutes. Within that sixty minutes there are hundreds or thousands of traders all competing to profit from the information. If you are in charge of one billion dollars, a 0.1% annual gain is worth one million dollars per year. Consequently, managers of those funds are applying considerable resources to squeeze out every little gain from new information. For this simple reason alone, there is an absence of opportunities for one trader to consistently profit from all other traders who have access to the same information at the same time! In short, all of us know more than any one of us and it is impossible for one person to consistently possess more knowledge than all the other traders combined.
In layman's terms, what is the Efficient Market Hypothesis?
The Efficient Market Hypothesis says that market prices are fair: they fully reflect all available information. This does not mean that prices are perfect; some prices may be too high and some too low, but there is no reliable way to tell. In an efficient market, investors cannot expect to earn above-average profits without assuming above-average risks. Market efficiency does not suggest that investors can't "win." Over any period of time, some investors will beat the market, but the number of investors who do so will be no greater than expected by chance.
Investors and market participants often confuse efficiency for rationality. The EMH does not state the markets are rational at all times. Studies show that the irrationality of the markets can be mainly contributed to increased demand. As recent as the late 90's we observed a significant demand push, more individual investors joining the markets coinciding with the internet boom, actually caused the markets to increase to unsustainable valuations.
It had nothing to do with the efficiency of the market but everything to do with irrationality of all the new investors.
As long as markets are free to trade, Adam Smith's invisible hand should work. The best assumption for investors is to assume that prices are fair at all times. Fair prices are prices where investors are properly compensated for the risk they bear over a reasonable period of time. If you think the price is wrong, you won't know for sure until long after the fact.
In Robert C. Higgins book, Analysis for Financial Management, he paints a vivid picture of how information is devoured by market participants: "Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are--plausibly enough--the piranha.
The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence."
Benjamin Graham is the most famous of all stock pickers. Ultimately, even he agreed with the efficient market theory. Eugene Fama's paper Market Efficiency, Long-Term Returns, and Behavioral Finance is the #1 downloaded academic paper on the web and explains the most recent challenges to this hypothesis.
The principal objective of the Cash Flow Portfolio is to generate reliable and consistent income from investments, while protecting investment capital through diversification. This income may come from stock or mutual fund dividends, interest from bonds and money market investments. Other forms of positive cash flow may be capital gains from sales of equities or from exchange of foreign currencies.
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About Me
TLassen is a 50-something private investor, despite being licensed for securities trading and portfolio management in Canada, has found himself in the Manufacturing environment for the last 30 years. His career has been spent predominantly in the aerospace industry and he is currently responsible for maintaining compliance to AS and ISO standards for a midsized company in Montreal.
His investment methodology is based on the concepts of economic added value. In plain English, investment returns have to be measured against investment costs. He uses fundamental analysis at the company level to identify best of breed companies and combined with the principles of economic added value, selects companies for long term investments.
The subtle point of Warren Buffet's statement, 'it is better to find a great company at a fair value, than a fair company at a great value' is often missed by investors who attempt to find undervalued companies regardless of their financial health. He belongs to the Buy and Hold camp, but has learned over the years to be flexible by taking profits off the table occasionally.
TLassen maintains 2 portfolios whose principal objectives are to generate reliable and consistent income while protecting investment capital through diversification. This income may come from stock or mutual fund dividends, interest from bonds and money market investments. Other forms of positive cash flow may be capital gains from sales of equities or from exchange of foreign currencies.
In other words diversify, diversify, and diversify some more, between and within the 4 asset classes: Stocks, Bonds, Cash and Tangibles.
His investment methodology is based on the concepts of economic added value. In plain English, investment returns have to be measured against investment costs. He uses fundamental analysis at the company level to identify best of breed companies and combined with the principles of economic added value, selects companies for long term investments.
The subtle point of Warren Buffet's statement, 'it is better to find a great company at a fair value, than a fair company at a great value' is often missed by investors who attempt to find undervalued companies regardless of their financial health. He belongs to the Buy and Hold camp, but has learned over the years to be flexible by taking profits off the table occasionally.
TLassen maintains 2 portfolios whose principal objectives are to generate reliable and consistent income while protecting investment capital through diversification. This income may come from stock or mutual fund dividends, interest from bonds and money market investments. Other forms of positive cash flow may be capital gains from sales of equities or from exchange of foreign currencies.
In other words diversify, diversify, and diversify some more, between and within the 4 asset classes: Stocks, Bonds, Cash and Tangibles.