One reason academically-inclined people give for investing in index-based funds is the “efficient-market hypothesis”.
(Another is the empirical evidence that index-based funds tend to outperform actively managed funds, especially after fees, over the long-run. But let’s put that to the side.)
The efficient-market hypothesis is a theory that states that asset prices (ie, financial assets such as shares) reflect all available information.
If this is the case, it’s impossible to beat the market because… well… the current price of a share reflects everything that’s known about that share.
This hypothesis was developed by Eugene Fama, who won a Nobel prize for his work.
There are variants of the efficient market hypothesis (EMH), often labelled along a continuum of “weak” and “strong” versions of the EMH.
There’s also my own variant, which directly contradicts the “efficient” part of the efficient market hypothesis, but comes to the exact same practical conclusion.
I think it is absolutely clear that financial markets are inefficient.
The evidence is all around: markets move up and down for all sorts of unpredictable and weird reasons. If markets were efficient, we wouldn’t have major downturns like the GFC (and future, inevitable downturns we can’t predict ahead of time).
The challenge is, financial markets are inefficient in ways that we can’t predict.
This blog is made possible by Fairhaven Wealth, my independent, fixed-fee, advice-only financial planning business.
The world is complex, and any single event doesn’t just have first-order effects. It has second-, third-, fourth-, fifth-, sixth-, millionth-order effects.
You can read annual reports about a company. You can analyse their most recent balance sheet, or their profit and loss statements. You can try to decide on what the company is “worth” based on these current values.
The challenge is, the real value of a company depends on its future. It depends on many factors that will influence the company over the short- to long-run. Like changes in the law. Changes in technology. Competitive pressures. Changing tastes. The broader economy.
If you try to value a share, you’re not just valuing the company as it stands now. You’re trying to make a bet, or a prediction, about its future.
The value of a share reflects the consensus value of these people’s predictions and expectations about the future. Think of it as the “wisdom of the crowd”.
They will be wrong. Because we will always be wrong about the exact contours of the future.
I can speculate about social, technological, economic, environmental, and political changes over the next few years or decades. But I’ll be wrong about most of these big picture things, even if I’m approximately right on some of them.
There’s no way I’ll be right at the big picture things, let alone how an individual company will perform within this broader picture.
I don’t think anyone else is likely to be right, either.
The question is: would I rather bet on my own assessments of what the future holds for a given share or the sharemarket in general, or try to pick someone whose assessments I think will be accurate; or do I rely on the “wisdom of the crowd”, which is the consensus view that is reflected in the value of a given share and the sharemarket in general?
Frankly, if I were to put my personal predictions head-to-head against another smart and engaged person (or team of people), I’m not sure whether I’d put money on me or the other person/team. My confidence in my ability to out-predict others would whither as the size of the competition increased to multiple people/teams, and would end up close to 0% once I was against thousands of other predictors.
As such, I’ll go with the consensus view. The wisdom of the crowd.
It won’t be right.
But it’ll be wrong in ways I can’t predict.
In this way, my inefficient market hypothesis leads me to the same conclusions as the efficient market hypothesis. I might as well treat the market for financial assets such as shares as “efficient”, because to the extent it’s inefficient, it’s inefficient in ways that I nor anyone else can predict.