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Challenges to Efficient Market Theory

The efficient market theory has been repeatedly challenged. After all, some stock pickers do quite well by following a specific strategy or investment discipline, which suggests that the market can be outsmarted. But the real test is whether any active investment strategy can consistently beat the market over a long period of time. As studies point out the number of funds outperforming the market is no greater than one would expect by chance.

From the perspective of Ken French, the tendency of past winners to keep winning and past losers to keep losing relative to their peers is one of the biggest challenges to efficient market theory. French argues that it’s hard for active managers to take advantage of stock price momentum because it’s a high turnover strategy and the transaction costs probably consume the potential gain.

Other investing methods that cast doubt on the idea that markets are efficient include seasonality strategies such as the “January Effect” and “Sell in May and Go Away”; the Dogs of the Dow approach; and the Dividend Yield and the PE-indicators. These strategies and others like them attempt to determine the future price of stocks based on market timing or specific characteristics of a stock or group of stocks. How do investors know whether a pattern is genuine or occurs by chance? The best way to verify whether a pattern is genuine and not driven by back-test bias is to look at out-of-sample statistical evidence. This evidence demonstrates that none of these strategies has yielded long-term market-beating results, and all require investors to take on greater risk and higher costs than the passive alternative.

What about market bubbles? Market behaviorists suggest that the internet bubble that burst in 2000 and the market crash of 2008 were signs that the market is not efficient. That is, the market was irrational and did not drive stocks to their proper valuations. However, based on all available information, the prices seemed fair and current trends looked like they would continue. “I’ve heard too many people who knew well before it happened that the 2008 financial crisis was inevitable”, says Daniel Kahneman in wonderful new book, Thinking Fast and Slow (2011). In his words, "some people thought well in advance that there would be a crisis but they didn't know it. They now might say they knew it, and claim credit for insight they do not deserve, because a crisis did in fact happen.

Only in retrospect did the tech bubble and the housing crash seem predictable and inevitable. When these markets crashed, it was clear that most forecasters were wrong. The money management industry would like you to believe differently so they can charge you more. One of their tricks is to make gurus out of the chance few managers and pundits who outperformed the market in the prior period or made a legendary market timing call. Unfortunately, there is no systematic way to repeat that performance.

Several studies have demonstrated that active management performance is remarkably similar to the random chance of a coin-tossing contest. In other words, it is luck, not skill that makes the difference. If this were not the case, many more active funds would not only outperform the market, but continue to do so year after year. But the winners are an ever-changing group, and the longer the time frame the greater the likelihood that an active investment manager will underperform the market. It beats common sense why so many investors continue to believe they can choose a strategy that can beat the market over the long-term.