AuthorTopic: Effeicent Market Hypothesis??
Hoss
@2010-01-01 16:44:23
How many of you believe the semi-strong form of the efficient market thereom? I am surprised that this is the main message of the portfolio management curriculum so far (levels I & II). If this theory is correct I should be advising all my clients to buy a selection of index funds to match their risk tolerances and return objectives, and that all these analysts, brokers and portfolio managers are just wasting our time and Wall Street is just a scam so brokergae houses and money managers can make big $$.

As an investment advisor/ broker, I would not need to know about company fundamentals or how to value a security. Rather I need to know a company's beta to determine if a stock is appropriate for my clients portfolios. Frankly, I do not think that a stocks risk is appropriately measured by its covariance with the market.

I have come across some very cheap value stocks with high betas selling below NAV, that have less downside risk than say Microsoft with a lower beta. From my real world experience individual investors measure risk as the possibility of capital loss over the long term (ie negative returns over 1 year or up to 5 years). Therefore, I believe annual semi-variance is more relevant in the real word.

The last implication of the theory that perplexes me is the notion that all investors should hold the market portfolio (ie S&P 500). I know of many franchise investors who successfully only invest in certain industries because they know them very well and consequently are comfortable investing there, and beleive the industry has better than average long term prospects. I would not advise Donald Trump to diversify out of Real Estate, but according to EMH he could decrease his so called risk and increase his potential return. Same goes for Bill Gates with Technology, and Warren Buffet with insurance. To these investors, risk is investing in something you have little expertise in and accepting the markets average return. I cannot think of any investors who got rich by holding the market portfolio.

I still believe in diversification, as I typically advise clients to hold 10 to 12 quality stocks and be willing to hold them for at least one business cycle (3 to 5 years) to realize their gains. However, I do not believe a portfolio manager holding 100+ stocks can consistently beat the market over time and after fees, as the portfolio is over diversified, it is basically the market, and the portfolio manager is just trying to outguess the short term moves of the market which are totally unpredictable. The manager cannot truly believe that his 100 stocks represent good value and outstanding business opportunities. If he did, why is the trading turnover of large money managers typically over 100% annually?

I think the academics behind EMH lose sight of is the fact that stocks represent ownership in an actual business, and it is owners of long term productive businesses bought at attractive prices that accumulate wealth. As Warren Buffet once said "I would be a bum with a tin cup if markets were efficient".Does anyone agree with my way of thnking or am I the lone critic of EMH?

Tstage
@2010-01-02 09:00:54
well-articulated. As a newcomer to finance, i wonder why buffet relies on mkt inefficiency when he is a proponent of value-investing ......i would think that mkt inefficiencies will benefit those in the mkt for quick profits i.e arbitrageurs. any thoughts on this?
stoploss
@2010-01-14 10:46:29
The efficient market hypothesis is only a model and like any model there are exceptions - However, I take exception to some of your perceived problems. First I would advise exam experts to diversify because since companies within sectors are tightly linked, diversification will decrease risk. Second, my feeling is that the markets are quite efficient but not totally efficient. What make the markets so efficient is that there are many smart greedy bastards (us) that keep prices in line. However, investment advisers (as you stated) stopped their analysis, the markets would cease being efficient.
Joram
@2010-01-17 22:54:32
I think, there are two key ideas here;
1. The inefficiencies make public uneasy and suspicious
2. The lack of the information and the excess of different kind of PR serves as a fuel for a panic.
It looks like Buffet knows about that pattern.
Guess what, if US will stop protecting the markets, Buffet "trading rule" will be hard to implement
Wildman
@2010-03-21 09:04:39
There's a lot of evidence that supports investing in index funds. As for franchise investors, sure you can pick up any magazine and find those types that invest in only specific sectors but they invest on behalf of a mutual fund's biotech, telecom, foreign markets, etc fund, the majority of them do not follow that strategy for their own portfolio. I'd be hard pressed to have the majority of my money in say biotech firms if I didn't have an MD or some sort of medical education to understand the nuances in clinical testing.As for Gates, did you know he's had a finance guy for years who's sole job is to basically dump 1000+ share blocks of Microsoft on a daily basis? Sure I'll bet he's still the majority owner but he's not riding tech only.In addition, it's impossible to really hold the market portfolio, the point of that suggestion is to be diversified by investing in a market index, and the CFA program cites studies that says it takes anywhere from 18-30 stocks to emulate similar benefits of holding the market portfolio.So the point is why should I pay you to pick 10-12 stocks when I can just buy an index fund and save a ton on transaction costs. By having an advisor hold only 10-12 securities, if one goes bust that's going to wreck 8-10% of the portfolio's NAV (provided equal allocation), plus you're going to have to replace say Enron, with Dynegy, Duke Power, or Calpine, which is going to cost me as a client to unload the Enron and then buy Duke Power.If I invest in an index fund, I'm going to have a lot more downside protection without sacraficing much in terms of the upside, it's just a more efficient portfolio.And as for market efficiency, markets are for the most part efficient in the US it's just that people don't read through everything. How many people want to pour over a 200+ page 10-K?That tells you everything but most people still just babble about P/E ratios and crap like that. In ibanking you'll see a ton of companies with high earnings and hence lower P/Es that suck because they've been divesting all of their various businesses/operations.

CFA Discussion Topic: Effeicent Market Hypothesis??

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I used your notes and passed ... highly recommended!
Lauren

Lauren