Wednesday, October 01, 2014

The Efficient Market Hypothesis

Investing, as with life, is a paradox. We have to learn to live with it and hopefully, sometimes, we find the way out. It is not rocket science. It's just about understanding the world and human behaviour. The world is ever changing yet human behaviour rarely changes. That is why it is so difficult for smokers to quit smoking even when we know that smoking is no longer as cool as when they shot Breakfast at Tiffany's. Yes, paradox. And it is equally difficult for diets to succeed and for value investors to dominate the investing world and for any investor to beat the market. Although that doesn't mean we shouldn't try :)

While this whole website and eco-system is built around value investing and trying to educate investors to understand value philosophy and to beat the market, we must be cognizant that the market is efficient. It is very hard to actually beat the market over the long run. Just as it is very hard for smokers to quit smoking or to successfully lose weight. Statistics showed that less than 10% of smokers can actually quit smoking without the help of medication and 95% of all fat people gained back their weight after some diet regime. In investing, about 10-20% of all investors will actually beat market return ie earn more than 8-10%pa over time.

In an era when smoking was still cool, Audrey would be asking, 
"Are you the 10% or are you just like Cat, a no name slob?"

The Efficient Market Hypothesis or EMH came about in the 1950s and 1960s when a bunch of professors in the University of Chicago and MIT did detailed research on the markets and came to the conclusion that most investors had never beaten the market ie the returns they generated were less than the average market returns of 8-10%. Over the years, the EMH has been debated to the death. Behavioural  finance "sort of" proved that humans are not rational when it comes to investing and hence EMH couldn't hold since one of EMH's core assumptions was that investors are always rational.

Also if the markets were truly efficient, how do we explain bubbles and how Warren Buffett and his group of Superinvestors beat the market for years and years? So is the EMH a fluke or is the market really efficient? Again, paradox.

I believe, as with all things in life, things are never binary. Everything must be explained in percentages (ie analogue basis, not digital). Type A people will never understand this. Let's hope more readers here are Type B.

The market is largely efficient. Maybe 95% of the time efficient. Bubbles and Warren Buffetts exist, but they do not refute the EMH. As investors, we must learn to respect that markets are, by and large, very efficient. To be better than the market, we must think better and see further and that ain't easy.

Why is the market necessarily efficient? 

As a simple analogy to illustrate this point, imagine that we stuff the National Library with $100 bills and get 10,000 people to go look for them. How long would it take before 95% the bills are taken? Not too long perhaps? A day or two? Yes, after that, there could be a few that are stuffed in between books like Security Analysis or War and Peace that might take some time for people to find them - that's where value investors look at.

The stock market is, by and large, like that. It is not easy to make money because everyone is looking for those dollar bills. Here's another paradox, the market did not start being efficient from Day 1. It became efficient as each and every investor took pain to extract the inefficiencies one by one.

The National Library analogy has its limits, so we need another one to better explain the structure of the stock market. The way that most investors (or shall we say speculators) play the stock market is hope to buy something and flip it fast, ie sell it to another buyer at a higher price. Now playing the market this way might make you money. But it is very tiring and you are far more unlikely to make it big. If the success rate for an average investor to beat the market is just 10-20%. Then playing this buy-and-sell-it-to-another-greater-fool game would likely have a lower success rate. Friend, don't make the game harder, already very pai(2) tan(3) liao(3), ho(2) sei(3) boh(2) ie already not easy to make money, pls wake up your idea.

So how?

Let's imagine now that there is a comic book store selling all sorts of comics from Marvel and DC Comics to Japanese manga to Hong Kong's Wind & Cloud or Lao(3) Fu(1) Zi(3). For a moment, also imagine that there is only one store in town and one copy for each comic. Some others might still be playing the previous game here, buy some comic in hope to sell to a Greater Fool. But a better way to play this is to: 

1) Buy a comic that is not expensive to start with
2) But also a comic that is interesting which you can rent out to others
3) Finally it is also evergreen such that the comic's rent price will actually rise over time

There are a few prices here. One is the price of the comic (ie the stock price) and there is the rent price (ie the dividend). The intrinsic value of the comic is determined by how much rent price it can fetch over its lifetime. The future price is determined by whoever willing to pay the highest. If you buy the issue #1 for Superman for $5 and you can rent it out for 5c every month, essentially you earn back the $5 in 100 months or 9 years (a bargain!) and you can sell that #1 of Superman for a higher price, provided the rent has then also increased to 10c per month. (Also imagine that both pirated paper and internet copies do not exist :)


#1 Issue of Superman in 1938

So you see, if you get the right comic, it will provide you an income and one that would rise over time. However you also want to buy them at the right price, because if you overpay, then it takes too long for you the reap the benefits. Say if you buy that same copy of Superman for $20, then it will take you 400 months or 35 years to earn back your cost, and you may not get to sell it at a higher price. That's poor investing.

The market is efficient here because there will be all these other comic buyers snooping for the good comics. Similarly there will be all these investors scouring the stock market for all the good stocks. Usually the buying price is at 12-18 earnings multiple ie it would take 12 to 18 years to earn back your cost. As you can imagine, it would not be easy to spot the great comics selling at a discount. You would have to be at the store every day, reading through all these comics and finding the real good ones which are undiscovered (think: reading a lot of annual reports and analysing a lot of stocks). And/or to wait patiently for some bargain sale some day and amazingly nobody is around.

Once in a while, the buyers disappear as they somehow collectively decided that nobody will read comics no more and you get the bargains. At other times, one or two comic become so superhot as to fetch prices that will take 100 years to earn back the cost (think Facebook, Alibaba). It's better to avoid the temptation to buy these hoping that you can flip and sell to a Greater Fool. Often, people find that they themselves are the Greatest Fools.

Most of the time though, the market is bloody efficient and very few outsized returns could be made. The Efficient Market Hypothesis works. While that is true, it doesn't mean that aspiring investors should just sit back and do nothing. For some, well, scouring for stocks year in year out really isn't their calling, then perhaps it would be better to buy the market (ie buy ETFs). And do other worthwhile things with our lives before we become food for worms.

For the rest of us, yes, we are here to figure out the paradox. Why are we born so that we become food for worms some day? Why try to beat the unbeatable efficient market? 

Because, we are here to seize the day and find as many gems while we can!
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