The Efficient Market Concept is A Big Bunch of Hooey

Those Who Believe in an Efficient Market Are Not Able to Say With Much Clarity What It Is.

The Efficient Market Theory posits that all that there is to be known about stocks is already incorporated into the price of stocks. Thus, there is said to be no benefit gained by learning things about stocks. Anything that you could come to know others have come to know before you and those others have caused this information to be reflected in the price available to you. Researching stocks is pointless, according to the theory. It is also pointless to adjust your stock allocation in response to price changes.

Efficient Market Concept There are grown men and women who claim to believe in this Easter Bunny of a theory (please see my note re the Easter Bunny comment posted at the bottom of this article). The thing is, it’s got a good bit of marketing muscle behind it. It’s been referenced on Jeopardy. It was recently named the official stock investing theory of the 2008 Olympics. I’m not even allowed to write about the efficient market on those days when I write my blog in my pajamas. The Blogger’s Code of Ethics require that I put on a shirt with a button-down collar and a tie before venturing an opinion on the market and its perceived efficiency or lack thereof.

I have found it to be a frustrating experience arguing against the Efficient Market Theory on discussion boards. It’s not hard to formulate the arguments. What’s hard is getting advocates of the theory to stick with a single definition long enough for me to be able to explain why a theory so defined does not hold water. Many people understand the implications of the theory — effective stock-picking is not possible, timing doesn’t work, stocks are always the best long-term bet, risk is always rewarded. Few (if any) can say with much precision what it is.

The things that people believe about stocks influence the price of stocks. We all get that. Saying that alone is like saying that water is wet; it doesn’t tell us anything beyond something that is so obvious that it isn’t worth anyone taking the trouble to tell us the news. The Efficient Market Theory must say something more than that or it wouldn’t have been named the official investing theory of the Olympics. It’s when the time comes to identify that all-important something else that the talk of efficient market advocates gets slippery.

Is the market price the right price? They say “no, not necessarily.” Is the efficient market concept rooted in a belief that investors are 100 percent rational? They say “no, not necessarily.” Does efficiency rule out price bubbles? They say “no, not necessarily.”

I’m writing an article about the efficient market and, truth be told, I don’t know what it is. I’ve read definitions of it in books and on web sites. The definitions I’ve read do not provide my brain with the nutritional information bits it needs to be able to make sense of this “theory.” I put the word “theory” in quotes because I personally do not believe this thing qualifies. My sense is that it is more properly referred to as an “assumption.” I sometimes think that even that suggests more solidity than is warranted; it might be that someday the efficient market will be looked back on as nothing more than a notion that was shared by a number of people for a certain stretch of time. On days when I am feeling footloose and fancy free, I have been known to refer to it as the Efficient Market Disease. I’m not a fan.

The Efficient Market is so ill-defined that trying to prove its nonexistence is akin to trying to prove the nonexistence of a ghost. The advocates of the theory give it no shape or outline or matter. So those of us seeking to prove its nonexistence are left saying: “Do you see all of that nothingness in front of you? That’s not a ghost as you insist it is, it really is just the nothingness that it appears to be!”

There’s No Efficient Market Unless Investing Is a Rational Endeavor.

Saying that the efficient market concept is so vague that there is no need to present an argument against it makes for an extremely short article. To insure that you get your money’s worth on today’s visit to my site, I am going to employ an assumption of my own for the purpose of giving the idea of an efficient market enough substance to provide me with something to talk about. I am going to assume that what the efficient market enthusiasts are trying to express is a belief that investing is a 100 percent rational endeavor.

Boring Investing Advice If investing is even slightly an emotional endeavor (it is primarily an emotional endeavor, in my assessment), I am not able to imagine any mechanism by which all information about stocks could come to be properly incorporated into the stock price. The only way by which I am able to make any sense at all out of the efficient market concept is to assume that its advocates believe that investing is entirely a rational endeavor.

The remainder of this article proceeds from that assumption. I argue that, even if investing were primarily a rational endeavor (I do not believe that it is), the Efficient Market Theory would come up short.

The reality (in my view, of course) is that, if investors were rational, they could easily see the irrationality of the Efficient Market Theory. It is only because investing is primarily an emotional endeavor that there are a good number even willing to entertain the idea that the market might be efficient.

There’s No Efficient Market If Important Information About Stocks Is Not Made Public.

The Stock-Return Predictor (see tab at left) tells you the most likely 10-year annualized return for stocks starting from today’s valuation level (this article was posted in November 2007), presuming that stocks perform in the future at least somewhat as they always have in the past. John Walter Russell and I began the research that led to publication of the calculator in May 2002 and published it in July 2006. Say that we both lost interest in the project in June 2006 and never published the calculator. The information transmitted to investors through the calculator would have existed in our heads but not in the heads of other investors. Would that not have given us an edge?

It would have given us an edge (it might take 10 years for the edge to be translated into enhanced returns, but it would be an edge all the same). Those who know something about stocks are better off than those who do not know that something. Research that is not published is known only to those who did the research. The market price cannot possibly incorporate all useful information because not all useful information is made public.

There’s No Efficient Market If Not All Investors Are Aware of All Public Information.

What percentage of investors knows about this web site and the Return Predictor? Let’s say that it is one-thousandth of one percent. That means that over 99 percent of investors do not have access to this information. Information that you do not know about cannot affect your investing decisions. Most investors have not seen the information they need to invest in such a way as to bring about efficient prices.

There’s No Efficient Market If Not All Investors Accept Important Public Information.

Of those who know about the Return Predictor, how many accept its claims as true? I’m certain that it is a number less than 100 percent because I have a distinct recollection of seeing on a discussion board a post from a fellow who entertained some doubts. If the claims of the Return Predictor are true, those who do not accept these claims are not able to act on the information provided by the calculator in such a way as to bring about efficient prices. (Conversely, if the claims are not true, those who do accept the claims cause inefficient prices.)

There’s No Efficient Market If Not All Investors Agree on What Action to Take in Response to Public Information.

Say that we were not concerned about all of the people who do not know about the Return Predictor or who do not accept its claims. Taking into consideration only the universe of investors who have the Return Predictor bookmarked and who use photos of the Results Page as the cover for the Christmas cards they send to friends and family, is it possible that the market price is efficient? It is not.

Investing Confused

For information to affect the market price to the extent needed to make it “right” or “efficient,” it must not only be known and accepted, it must also be acted on appropriately. Even the authors of the Return Predictor cannot tell you with certainty how to act on the information obtained through use of the Return Predictor. John and I from time to time discuss this question in e-mails. We agree on many points; we do not agree on some. On some, we both acknowledge that we have more to learn. We don’t know it all and it is highly unlikely that any of the users of the calculator today know it all.

Different users of the calculator are coming to different conclusions as to the strategies to adopt in response to tapping into the information it provides. As new investors learn of the calculator, it is put to new uses and its effect on the market price changes. If the calculator is having one effect at one time and another effect at another time, it cannot be having the “right” effect at all times. The efficient market is an imaginary construct.

There’s No Efficient Market If Investors Do Not Agree on What Information Is Important.

I think that the Return Predictor is a powerful investing tool. Mel Lindauer (co-author of The Bogleheads Guide to Investing) thinks it is a piece of smelly garbage. Who’s right?

For purposes of the argument put forward in this article, it doesn’t matter. If I am right, Mel’s stubborn unwillingness to agree with me re the value of the calculator is causing the market price to go a wee bit off. If Mel is right, my stubborn unwillingness to acknowledge that the calculator is a piece of smelly garbage is causing the market price to go a wee bit off.

For the market price to be “right,” investors would need to be able to know with certainty what information is of value and what information is not of value. The fact that there are disagreements about how best to invest (and I think it is fair to say that the Lindauerhead Lions are not going to lie down with the Bennetthead Lambs anytime real soon) shows that at least some of us do not know with certainty what information counts.

There’s No Efficient Market If Some Investors Do Not Act on Important Public Information That They Accept.

Say that everyone knew how best to respond to the information contained in the Return Predictor. The market price would not be efficient even in those circumstances. Many of the people who used the calculator and learned from it would never get around to changing their stock allocations in response to what they learned. Did you ever fail to make a dental appointment that you knew was needed? Did you ever fail to bring your car in for an oil change in the time recommended?

Information not acted on has no effect on the market price even when the information in some theoretical sense should have an impact.

There’s No Efficient Market If a Large Number of Investors Comes to Believe That There Is An Efficient Market.

Investing Mistakes

A large number of investors have come to believe in the Efficient Market Theory in recent decades. That change in the investing realities affected market prices. For one thing, belief in the efficient market has made large numbers of investors complacent about high valuations. This change in public attitudes about how stock investing works itself disproves the theory.

Before there was a widespread belief in an efficient market, people invested one way. After the belief came to be widespread, people invested another way. The two different ways of investing produced different market prices. Either the earlier way of producing prices (disbelief in the theory) was right or the new way of producing prices (belief in the theory) is right. Both things cannot possibly be so.

There’s No Efficient Market If Investors Become Emotionally Attached to the Idea of an Efficient Market.

Say that a large number not only comes to believe in the efficient market, but becomes emotionally attached to that belief because it enjoys outstanding stock returns during the time-period immediately after it comes to believe in the theory. Such investors would respond differently to criticisms of the theory than investors who merely assented intellectually to the theory (for one thing, they would be less willing to revise their views after being presented with evidence that they are faulty). Again, this would cause a change in prices. Again, the market price could not have been “right” both before and after the time at which the emotional attachment was developed.

There’s No Efficient Market If Investors Are Not Motivated Solely To Make a Profit from Investing.

Say that all investors possess perfect information but not all investors are motivated solely to make a profit from investing. In that were so, the market price could not be efficient. People would be taking actions different from the presumably efficient actions that would follow from acting to enjoy a profit and those actions would be affecting prices, causing prices to be something different from what they would have been had profit-seeking been the only motive with an influence.

Are there people who invest with motives other than to make a profit from investing? There sure are. Many transactions are completed by mutual-fund managers. The primary motive of many mutual-fund managers is to persuade people to invest in their funds. The investment decisions likely to produce strong long-term returns are often different from the investment decisions likely to persuade people to choose a fund (many investors focus on short-term results in deciding what fund to choose).

Even mutual fund managers who possessed perfect knowledge of how to invest effectively would feel pressures to dumb down their investing decisions to remain in business for the length of an out-of-control bull market. In cases in which mutual fund managers make less than optimal choices, the market price is rendered inefficient.

There’s No Efficient Market If Prices Go to Extreme Highs or Extreme Lows.

Can prices go to extreme highs or lows in an efficient market? They cannot. When prices go to extreme highs, the long-term return on stocks drops to levels lower than the long-term return on super-safe asset classes. There is no rational reason to invest heavily in stocks at such times. Why would someone invest heavily in a risky asset class when a better return was available from a non-risky asset class?

The reality is that prices do go to extreme highs and lows. The efficient market is an imaginary construct. That’s the layperson’s way of saying it. If you spend much time hanging around the Big Wheels in the investing advice biz, you’ll sooner or later catch us using the technical terminology generally reserved for insiders. At our professional conferences we might not employ the plainspeech saying that the efficient market is “an imaginary construct.” We might go professional on you and observe that it is “a big bunch of hooey.” Please don’t be intimidated by the lingo. The intended meaning is the same.

Efficient Market Dangers

There’s No Efficient Market If Any Stocks Are Held by Humans.

Humans are emotional creatures. That means that they do not act only in response to information bits. Their decisions are influenced by emotions — fear, greed, envy, panic, all sorts of things.

Even if all information were incorporated perfectly into the market price, the efficient market would be an imaginary construct. Information is not the only influence on prices in a world in which stocks are owned by humans.

The Efficient Market concept is a big bunch of hooey. Tell your friends. Let’s work together to make stock investing safe for humans again!

Note re the Easter Bunny comment: I do not believe that people who believe in the efficient market are dumb. All human beings are flawed. We all do dumb things from time to time. Those of us who have come to believe in the efficient market have done a dumb thing, in my view. It is not my intent to insult those people by pointing this out. My intent in putting forward a comment like the Easter Bunny comment is to get them to stop and think and perhaps reconsider. I am sure that these people have much to teach me and many others about many other aspects of the investing project.

Investing for Humans

Could it be that I am the one who is doing a dumb thing? It could indeed be that that is the case. If you believe that that is so, I hope that you will consider taking some time out of your day to show me where I have messed up. May you say that not believing in the efficient market is as dumb as believing in the Easter Bunny? You may. Please just try to keep it lighthearted enough so that we may remain friends while disagreeing on this investing topic (and please let me know if you ever think that I have crossed the line and permitted my strong criticisms of an investing theory to become personal insults).