Is it Possible to Beat an Efficient Market?
(Updated August 2020)
Active investment managers encourage the idea that one can beat the market with superior skills in market-timing and security selection. This idea appeals to investors who misunderstand how markets work, believing that they can achieve better results by selecting the best money manager. The financial press supports this idea with a never-ending supply of articles on the best stocks, strategies, funds, and forecasts. The message is always the same: don’t settle for ordinary results. Aim high and beat the market!
Now let’s peek inside the investment profession. Here you’ll find many bright, talented people who love the high stakes and high potential rewards of investing. It’s no wonder that some of each generation’s greatest analytical minds are drawn to investment research. Ironically, the intelligence and skill of these competitive professionals makes the probability for break-out success quite low.
Imagine a single securities transaction. The buyer has concluded that the security is worth more than cash, while the seller has concluded that cash is worth more than the security. Each has carefully evaluated all publicly available information concerning the stock, and yet managed to reach opposite conclusions. At the moment of the trade, both parties are acting from a position of informed conviction, even though time will prove one of them right and the other wrong.
For instance, one investor may believe an excellent earnings report from Apple makes the stock a buy; another may feel that the stock has nowhere to go but down the following quarter. This example is repeated millions of times daily in markets around the world. Stock picking experts and research analysts compete aggressively to find stocks they believe to be over- or under-valued to trade for profit. But in open, free, and competitive security markets, their transaction price is a consensus of a security’s intrinsic value. This is the nature of an “efficient market.” And in an efficient market it is difficult to imagine that a security’s market price will depart meaningfully from its true underlying value.
The efficient markets hypothesis (EMH) is the organizing principle for understanding how markets work and what investors should care about. The idea of efficient markets is so natural that it's probably been with us for centuries, Robert Schiller writes in "Irrational Exuberance" (Broadway Books, 2000). The term first became widely known through the work of Professor Eugene F. Fama of the University of Chicago. Fama and his colleagues performed extensive research on stock price patterns in the late 1960s and published a paper reviewing the theoretical and empirical literature on the efficient markets model (Efficient Capital Markets, The Journal of Finance, Vol. 25, No. 2, May 1970). The paper asserts the following:
• Securities prices reflect all available information and expectations
• Current prices are the best approximation of intrinsic value
• Price changes are due to unforeseen events
• Stock prices follow a random walk and are not predictable
• Although stocks may be mis-priced at times, this condition is hard to recognize.
In other words, an efficient market incorporates into current security prices relevant known information as well a consensus expectation regarding the unknown. The most important premise of the efficient market is not that new information is disseminated rapidly, but that not all traders translate new information in the same way. If new information is the main driver of prices, only unexpected events will trigger price changes. This may be one reason that stock prices seem to behave randomly over the short term.
No matter how powerful a trader’s analytical tools, or how sophisticated their understanding of the industries they study, or how deep their knowledge of consumer and market trends, the fact remains that it is virtually impossible for traders to reliably beat the market by gathering and analyzing information. It follows then, that most active money managers, with their associated direct and indirect transaction costs, will underperform the market over time.
If professionals with virtually unlimited resources cannot apply research and analysis to pick winning stocks, it is even less likely that individuals can outperform the market. The futility of speculation is good news for the investor. It means that prices for public securities are fair and that persistent differences in average portfolio returns are explained by differences in average risk.
Market efficiency does not rule out the possibility that some money managers will earn above-normal returns. 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, and any effort to beat the market comes with added risk.
Without realizing this, many investors continue to compare their performance against the results achieved by the latest investment superstar. These misguided investors chase performance numbers by constantly reallocating money from one manager to another. They are always in the hunt for the elusive money manager who can produce the same superior performance tomorrow that someone else produced yesterday. Even in rare situations where a money management organization has a unique proprietary insight that produces a superior result, the expectation is that the advantage will be eroded over time as other money management organizations discover and exploit the process.
The tremendous growth in the use of index funds serves as tangible evidence that money management today is being transformed, moving away from attempts at market timing and stock selection to the more important principles of asset allocation and diversification. Rather than trying to out-research other market participants, passively-managed index fund portfolio managers like Cardiff Park Advisors look to asset class diversification to manage uncertainty and position portfolios for long-term growth. The goal is not to beat the market but to devise appropriate long-term strategies that will move investors toward their financial goals with the least amount of risk. These strategies do not fight the capital markets so much as they intelligently ride with them.
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For more information about Cardiff Park Advisors please review our brochure at https://adviserinfo.sec.gov/firm/summary/126752 or visit www.cardiffpark.com