As you know, economists are scientific types that study how money flows and grows. They study many different aspects of this very broad concept, including how stock market prices behave. Being scientific types, they love to develop theories that explain many different “phenomena.” One particularly important theory that has been the foundation of America’s retirement strategy since the invention of the 401K is the Efficient Market Hypothesis (EMH).
In its simplest form, the theory holds that the price that stocks sell for factors in all available information, and thus no trader can have any real advantage over the other. The idea of efficiency comes into play because the market has already priced each stock given all of the relevant information. If stocks are priced to reflect this efficiency, then it is impossible to pick undervalued stocks to buy and overvalued stocks to sell because those things cannot exist in an efficient market.
This translates into the following investment advice: Stick all of your money into a low-cost mutual fund that reflects the entire market and hope that the overall economy grows. This is the strategy that many 401K “experts” dole out to folks hoping to have enough money to retire one day. Put some in an Index Fund, put some in bonds, and put some in annuities, then wait for retirement. Any scientist (I classify economics as a social science) will tell you that it is much easier to disprove a theory than it is to prove one.
To disprove a theory, all you need are some examples of it not working. The EMH doesn’t hold up in the face of short-term performance legends like Jim Cramer. It doesn’t hold up well in the long run when we consider the mind-boggling success of the long-term value plays of Warren Buffet. Unless you believe that Mr. Cramer and Mr. Buffet are magical creatures, then you must reject the EMH as an absolute law of economics.
In fairness to the supporters of the EMH, it must be acknowledged that any randomly selected portfolio has a very small chance of beating the market by a substantial margin. The laws of probability are clear on that one. Any fund managers that beat the market for a quarter or even a year may well have random chance to thank for their success. In everyday language, this probabilistic growth would be a case of “getting lucky.” Another law of probability tells us that improbable events occurring in a long series become very, very improbable.
Take poker as an example. If we are playing and you get a full house, I’ll say that you got lucky. If you get a full house twenty times in a row, I’ll say you are cheating because that happening by chance is just too improbable—nobody is that lucky. When I look at the careers of great investors like Jim Cramer, Warren Buffet, and Peter Lynch, I must reject the efficient market hypothesis. There are other lines of attack on the theory, such as the impossibility of a “market correction” if the hypothesis is true, but I hope I’ve made my point.
My ultimate conclusion is that you can indeed perform better than the overall market. I would be remiss if I didn’t point out that doing so is not easy. While I’ve argued against the EMH, I will say that it is mostly accurate most of the time. Most stocks do trade right around where they should. Finding an undervalued stock is wonderfully hard work. Identifying a catalyst that will send it upward is more work still. Even so, with a little luck and a lot of homework, you can beat the market.
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