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!

On Wikipedia and Markets

I was reading this book "The World Is Flat" and this small little story on Wikipedia caught my attention. Btw this is quite an old book and one can so obviously deduce I am so behind in my reading... I think the author has written like three updates and published at least a sequel. There wasn't much of truly good insights but lots of small interesting stories which makes it an entertaining read and perhaps that's why it's selling million copies.

Anyways the story on Wikipedia was that even though it was a free encyclopedia,  contrary to popular belief that Wikipedia has a lot of crap, things posted can actually be quite accurate. The rationale was that for every topic, there will always be those that are Pro and Against. So the Pros will write their story, but whatever is overboard gets deleted by the Against. This goes on until what is written on it presents the most valid view and nobody edits the page any further.

Of course this only works when there are many people editing the pages. At the end of the section, the author did state an example where a senator was accused of involved in killing JFK on Wikipedia, and since a lot of sites simply take what is on wiki, he was shocked to find newspapers calling him asking  whether he killed JFK. Similarly you can go and write a wiki page full of rubbish to spite your idol's rival and if not enough fans edit the pages, you achieve your aim.

Now the link here is that markets work in the same way too. Someone who thinks the stock is too cheap buys it, someone who thinks otherwise sells it. Until equilibrium is reached. Now this equilibrium is based on every market participants judgement on the stock at that point in time. So the current stock price should reflect the most efficient price to most of the participants at that time. This is the basis for the efficient market hypothesis.

Needless to say, if the stock is very thinly traded, ie not too many people have an opinion on it, the stock can be mispriced and stay mispriced for a long time. Value investors buy stocks that are  mispriced by being very cheap and wait for the market to find its true value. Or in the Singapore context, these stocks get taken out private at a cheap price. Of course, the way the human mind works, a lot of people actually don't mind overpaying for garbage, like companies with no earnings, LV bags and Mickey mouse apartments at $1000psf. So stocks can stay mispriced on the upside for a couple of years too.

Now you might be asking if the market is efficient, how does value investing fit in? If the stock is always at the right price, there is no gap between price and intrinsic value, how can value investors benefit then?

The answer is Patience. Most of the time, price trade very close to value. There won't be 50% upside. But there will always be times when things go out of whack. In the big way, it would be like 2007 financial turmoil, where great companies get whack down to very cheap levels even though nothing much has changed in their businesses. Think Coke or P&G, do people stop drinking and stop shampooing in a financial crisis? In the minor ways, some stocks trade down on temporary, one-off issues. Most market players then get emotional and judge the stock only in one direction (ie down) in the span of that few days or weeks.

E.g. bcos of bad weather, less people go out shopping, fashion clothing stocks get sold down. We all know that girls need to change their wardrobe every month, so when chances like these come by, just go buy Gap or Victoria's Secrets or Zara. (disclaimer: I have never researched these co.s, just arbitrary naming fashion stocks) Sooner or later, they go back up to their true value.

In a sense, this is how value investors can beat the market. But this is still easier said than done. Well at least now we know Wikipedia may be more accurate than your beloved local press reporting, so for those who thinks Wikipedia is unreliable, give it more credit!

Companies that shouldn't exist

The market is efficient and smart, but only to the point of the average smartness of all its investors. Hence it allows companies that spectacularly generate low or even negative return on capital to exist for very long periods of time.

The No.1 ranking company that achieve this tremendous feat would probably be Chartered Semiconductors, our beloved high tech foundry.

Over the past decade, the company had lost over a billion dollars culmulatively, burnt two billon SGD of cash and generated a spectacular ROE of negative 6%. It has never paid a cash dividend in its entire existence and have asked for money countless times.

Considering that cost of capital is around 6% (see previous post), Chartered failed to even come close. In fact, Chartered helped investors LOSE 6% every year. Yet the market cap of Chartered had been around S$2bn for the good part of the past 10 yrs. (its peak was a whopping S$7bn during the IT bubble and trough a miserable S$300mn during the Lehman shock.) Why would such companies exist in a rational, efficient world?

Well the stock market is just one aspect of the economy I guess. Chartered provides tens of thousands of jobs considering all the peripheral companies that it supports, we cannot just let it go down right? So we did the next best thing, we sold it! And thank goodness, Chartered will be delisted.

Why has a company like Chartered lingered around for so long? Well market participants always had hope and greed and of course Chartered did serve some purpose for punters. Back in the IT bubble, it was so clear that Chartered would be a STAR. It made chips for goodness sake. And chips are what make IT possible. so that was the eternal hope. Even when the company started burning REAL cash for Hungry Ghost festival every year, investors held hope. It's biggest shareholder, Temasek, never gave up. Well until now, that is.

Here lies the new insight I have about efficient markets. Markets are efficient in the short run, ie 1-2 yrs where almost all market participants share similar thought horizon and are able to price stocks very efficiently within this time frame. And markets are efficient in the very long run, ie more than 10 yrs - companies that ultimately shouldn't exist would go, like GM, like some airlines, and perhaps Chartered. And of course, Great companies will rise through the ranks and become behemoths and rule the world, like Walmart, Toyota and Nestle etc.

The Efficient Market Revisited

There has been a lot of debate since the 1950s whether markets are efficient or not. Btw, if you are asking what the heck is an Efficient Market, you can read this posts first.

Label: Modern Portfolio Theory

Ok Efficient Market. Essentially, some academics came out with this theory that nobody can earn a superior return than the market return (ie average investment return) over an extended period of time bcos markets are damn bloody efficient. ie if there is an inefficiency (or a discrepancy between price and value), eg a stock is worth $5 but is only trading at $3, people will simply keep buying the stock until it is fairly valued. So no matter how hard you try, you can only earn the average index/market return if you invest in stocks/bonds whatever, which is about 8%pa.

As with academics, they made it complicated. So they came up with three forms of Efficient Market which I have forgotten what they are. But the message is nobody can beat the market whether you use fundamental analysis, or technicals or whatever intelligent tools you can come up with. So even if you managed to spot one inefficiency, you are just lucky and you won't be able to do it over and over again. The academics dare you to prove them wrong man! They really do! And sadly I think they are winning. Not 100% but quite close.

Having said that, actually there is a flaw in the EMH, or Efficient Market Hypothesis. The flaw is that the markets are not efficient to begin with. It becomes efficient bcos the market participants are constantly taking out the inefficiencies. Imagine 1 million investors/speculators in the market and everyone just managed to spot 1 price/value discrepancy, then the market will be quite efficient already right?

So the markets become efficient bcos there are lots of participants taking out the inefficiencies all the time. The thing is that most participants can probably pick out 1 or 2 inefficiencies during a certain time frame but not a hell lot over long periods. Hence in general, markets are quite efficient to any one person.

But what if they are those who can consistently spot inefficiencies and earn the difference between price and value? Does that mean that the market is not efficient? In my opinion, the markets are still efficient it's just that this group of people have superior tools to enable them to pick out more inefficiencies than others. Of course for those still blur blur one, we are talking about value investors.

One reason why value investors can do this is bcos of their investment philosophy and investment horizon. Most pple nowadays go for instant reward, taking quick profits. They are not interested in owning businesses, waiting for its value to grow over time. They want profits NOW. Hence although a lot of people may know about value investing, they either

1) don't believe it works; they just don't believe in the owning business thingy
2) may not want to practise it bcos it takes too long to see the fruits
3) they think they are practicing value investing but they still buy and sell stocks like oranges or mobile phones or cars

So those Superinvestors for Graham and Doddsville patiently buy businesses while the world revolves around trading stocks like oranges or mobile phones or cars and Voila! They beat the major indices flat with their 30 yr track record of 25-40%pa. But sad to say, there are probably only a handful of these people and they don't really have a strong statistical argument against the Almightly Efficient Market.

Conclusion: The markets are not 100% efficient but they are efficient enough such that you don't get a free lunch if you don't work hard enough for it. Work hard = read books / annual reports, do a lot of macro, industry, company analysis etc.

Asset Allocation

As a seasoned value investor (for those who have been following this blog, hopefully you have become one), asset allocation is a must-know.

Remember we talked about portfolio theory, Markowitz, efficient frontier and the kind of crap. Umm well, actually not that crappy, got win Nobel Prize one, don't pray pray ok. For those blur, read this post. Now in order to earn a return that is on the efficient frontier, meaning the portfolio is so efficient whatever you put in goes straight into your bank account x 10% and then gets immediate giroed to pay your credit card bills.

No, to earn a return on the efficient frontier means that this return can be earned with the least risk possible. Say if you target 10% return, but your portfolio risk is 25% while the risk of a portfolio on the efficient frontier is only 15%, then you loogie big time, bcos your portfolio is not efficient at all and you should really go put some oil on your money to make it run smoothly or something.

So how do we make our portfolio efficient? The answer lies in asset allocation. Asset allocation simply means determining how much to put in different asset classes such that the risk and return will be optimal, i.e. the portfolio is on the efficient frontier.

Back in the good old days when we have only 3 asset classes, the classic answer is 50% stocks, 40% bonds and 10% cash or some similar variation, say 60% stocks, 30% bonds and 10% cash etc. But today, we have 10,000 asset classes, so things are not so simple anymore. An efficient portfolio probably looks like this

40% stocks
10% bonds
10% hedge funds
10% real estate
5% private equity/venture capital
5% commodities
5% gold
5% cash

For a more scientific asset allocation, go google for Havard Endowment’s asset allocation, and you can see how the pros do it. If you want to be better then on top of the above mentioned asset classes, maybe you should consider adding

1% art and antique
1% wine and coke bottles
1% watches and diamond rings
1% krisflyer miles
1% adopted chinese brilliant kids
1% securitized future cashflow from this blog

Ok that’s just for fun hor, don’t follow blindly. The point that is being illustrated here is that current wisdom advocates finding more asset classes that are uncorrelated and then putting some portion of your portfolio in them. (This post has more info). The truth is for the retail investor, finding exposure to asset classes other than equities, bonds and real estate is actually not that easy. Most hedge funds and private equity funds will not accept retail money. But I always believe that when there is a will, there is a way. If you think you really want a well diversified portfolio then you will find ways to do it. Next post of a typical asset allocation for a Singaporean household, watch this space!

See also Efficient Market Hypothesis

Diversification or diworsification?

According to Markowitz (he is a Nobel Prize Winner on Portfolio Theory), diversification is the only way to achieve a higher return at the same level of risk. This actually makes more mathematical sense than common sense, and most value investors do not subscribe to this thinking. Let's try to examine whether diversification is actually diworsification.

To paraphrase the essence of Markowitz's theory, basically it means that if you are only willing to accept the risk that you will lose, say 10% of your principal, and a portfolio of stocks and bonds can give you 8% return, the only way that you can earn more than 8% is to invest in other asset classes like commodities, real estate, bonds, private equity, integrated resorts, submarine fiber optic cables and credit card points. (Ok the last 4 are not socially accepted asset classes btw)

In order to achieve the maximum positive effect of diversification, the asset classes should also move in different directions, i.e. when one goes up the other should go down. This way, say if equity markets crack, hopefully bonds or commodities will still help to offset some losses. Ok we all know that's bullshit right?

Buffett and Peter Lynch (he is a star fund manager at Fidelity some time back, quite famous too) thinks diversification is bullshit too. Lynch calls it diworsification. This is bcos all of us have limited time and resources, and it does not make sense to try to invest in as many field as possible since we can only be an expert in only a handful of them. You should bet your entire net worth only when you find a potential ten bagger (a stock that will rise 10 fold) and only if you are damn sure. This way you maximize your effort in research, make money, feel happy and can go buy that Prada bag for your wife and that Ferrari for yourself.

I kinda think that the truth is again, somewhere in between. Diversification helps to a certain extent, but not as good as what is promised by textbook, but if you don't diversify, chances are that one basket that you put all your eggs will break. (Trust me, Murphy's Law works.)

As individual investors, diversification options are actually quite limited, we do not have access to some non-conventional asset classes like commodities and private equity. Most people will have to stick with bonds, equities and cash. Even so I think there are some benefits that could be reaped. E.g. by investing in stocks in the different sectors or different countries. You don't need a 100 stock portfolio to enjoy the benefits of diversification, the textbook says 30, personally I think anything more than 5 stocks should be good enough.

Of course, when the markets correct, like last week, correlation of all kinds of asset classes that you can think of goes to 1. i.e. everything will crack together, commodities, bonds, stocks, real estate, private equity, Toto, CoE, salaries etc. And diversification fails. But by and large, diversification should help to generate a better return for the same level of risk.

See also Efficient Market Hypothesis
and What is the Stock Market

CFD Diversity

Add diversity to your stock portfolio by trading CFDs. CFDs are margined products so a trader only has to put up a fraction of the cost of the stock. A trader can profit from both rising and falling prices in value if the right choices are made. A properly placed stop loss can help to manage any risk.

Risk, Return and the Markowitz Portfolio Theory

Harry M. Markowitz won the 1990 Nobel Prize for telling the world two fundamental truths about investment: "Higher risk, higher return" and "Don't put all your eggs in one basket". Much as I sounded as if he deserved the Novena Primary School Mathematics Competition Runner-up, I must point out that his findings were mathematically elegant. (I know you are saying "yeah right" but trust me, it's true, I was genuinely amazed by the beauty in its simplicity.)

Nevertheless, the important implications of his modern portfolio theory still hold true in today's investment arena.

To briefly summarize what was his theory all about, we need to assume that the markets are efficient. The efficient market hypothesis essentially assumes a lot of things that do not make sense but academics love them anyway. Just to mention a few, efficient market assumes that all investors are rational (well if you think monkeys are rational), zero transaction cost (hmmm if sell-side analysts are monkeys and work for bananas) and that information flows freely (monkeys talk to one another all the time and need not buy one another bananas for info) etc. These we all know are not true.

However, that is not the point, the point is once we assume markets are efficient, according to Markowitz the only way we can make more money is to

1) To take more risk (by investing in riskier assets)

2) To diversify (by investing into different asset classes which are not correlated)

This is graphically represented above in what is known as the Efficient Frontier. The Efficient Frontier represents the maximum return that can be achieved at a specific level of risk. If an investor wants to achieve a higher rate of return, she can invest in riskier assets, like equities or venture capital (This is the "Higher Risk, Higher Return" part). This can be easily visualized as shifting from one point (e.g. Bonds) to another point (e.g. Equities) on the right of the same Efficient Frontier.

Now she can also choose to invest in many different kinds of assets (commodities, real estate etc), hence not putting all the eggs in one basket. This will push out the Efficient Frontier (a parallel shift of the whole Efficient Frontier upwards), enabling the investor to reap more return for any given level of risk.

So as I said, elegant math that explained two truths about investment.

See also Efficient Market Hypothesis

and Irrational Exuberance

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.

See also Risk, Return and Markowitz Portfolio Theory

and Irrational Exuberance