There are people who believe the earth is flat.
There are others who believe we’re living in a computer simulation.
Or that a hidden race of Lizard People are running society from the shadows.
There’s a whole lot of different ways to make sense of the world we live in.
The same goes for the financial markets.
There are those who believe in the so-called ‘50% Principle’ — that any uptrend must correct by 50% before resuming its rise.
Others prefer ‘Odd Lot Theory’.
This is the idea that when smaller investors sell out of something, it’s because they’re wrong, and it’s therefore a good time to buy.
I know of one allegedly very wealthy investor who believes every financial market on the planet — property, stocks, commodities, you name it — moves in a repeating cycle, in which prices rise for a certain number of years, then fall for a certain number of years.
In today’s newsletter, though, I want to introduce and compare two of the less far out — and more influential — theories about the market.
100% Efficient? 100% Of The Time?
Efficient Market Hypothesis (EMH) claims that the price of any investment reflects everything the market knows about it at any given time.
In other words, the market ‘prices in’ all available information about an asset.
Because of this, it’s impossible to ‘beat the market’, as the market already knows everything you could know.
The market is, in this theory, all seeing and all knowing.
EMH is more than a century old and is most often attached to American economist Eugene Fama.
It’s crucial to understand that in Fama’s EMH, he’s talking about whether one can beat the market without taking on any extra risk.
Anyone who beats the market’s returns can only do so by taking on additional risk.
Many investors, of course, aren’t keen to do this — which is possibly why there’s been such an appetite for passive ETF investing in the past few years.
EMH believers believe in keeping investment costs low and not bothering trying to outperform the perfectly priced market.
Opponents, on the other hand, believe you can. Even without taking on additional risk.
Why?
Because the market is NOT perfectly efficient. Prices do deviate from their fair, or intrinsic, values.
Enter the next theory of how the markets work.
The Market Is A Drunk Man.
In 1828, Scottish botanist Robert Brown dropped grains of pollen in water.
He observed that, suspended in the water, the pollen moved in a rapid, and random, oscillatory motion.
About 70 years later, French mathematician Jules Regnault found that the longer you held a stock, the more it deviated from the price you paid for it.
These two experiments form the bases of Random Walk Theory.
This theory posits that asset prices change at random. Past prices are of little use in predicting future ones.
And, to make our lives even tougher as investors, the market being the efficient (in theory) animal that it is, prices in all available information to these ‘random walks’.
Economist Burton Malkiel popularized this theory in 1973 with his book A Random Walk Down Wall Street.
He called stock price movements the ‘steps of a drunk man’.
Random, unpredictable, unreliable.
Random Walk Theory is another view of the market that leads followers to believe that it is impossible to predict or outperform the market.
At least, not without taking on any extra risk.
What Do I Think?
I personally believe the market is not 100% efficient.
I believe it is quite efficient, but there is always room for improvement.
As a value investor, I believe at any given time there are stocks that are over and under their ‘true’ value.
As the legend Warren Buffett says, ‘in the short run, the market is a voting machine but in the long run it is a weighing machine’.
And as John Maynard Keynes said — the market doesn’t reward investors for being smarter than it…
It rewards them for taking risk.
More on that in a future edition.
Knowledge pays the best interest,
Navarre
The Data-Driven Investor
