Friday, May 26, 2006

The Efficient Market Hypothesis (or EMH), its myth and reality

The Efficient Market Hypothesis states that stocks or other investment instruments always trade at their fair value (or intrinsic value) because investors always react rationally to new information entering the market and prices would instantaneously reflect this. Hence it is futile for people to try to beat the market (i.e. try to earn more return than the average market return) through stock-picking or by other means.

In fact, one book says that you can open the newspaper page on stock quotes, give a monkey some darts to throw at the stocks and then buy them (the stocks, not the monkey). Voila, the stocks will perform as well as those picked by a professional fund manager. And you can pay the monkey truckloads of bananas.

In everyday life, EMH is similar to saying it is very hard for you to find money on the ground while shopping along Orchard Road, because chances are someone has already picked it up.

However, if the EMH is true, and nobody could beat the market, how do we explain Warren Buffett, or Peter Lynch? These are people who has beaten the market for not 1-2yrs but 20-30yrs, and they made 20-30% per annum, far higher than the average of 5-8%.

As with most things in life, I think the truth is somewhere in between. The market is efficient and it is hard to find undervalued stocks, but there are people who are "six sigma events", like Tiger Woods, Michael Jordan, Mother Theresa, Albert Einstein and Warren Buffett. With effort, practice and knowledge, we can still invest and make money, we may never earn 30% p.a. but 8% p.a. is not unachievable.

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