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.
I think the efficiency of the market is not a binary situation. It is not just 0: the market is inefficient, or 1: the market is efficient.
ReplyDeleteI would like to look at it as spectrum, i.e. the market is 10% efficient or 90% efficient. In Singapore, and with smaller markets, I think efficiency is lower. For Singapore maybe 60%. For the US, maybe 99%.
how could you arrive at this statement:
ReplyDeletein singapore & with smaller markets, the efficiency is lower. For singapore, it maybe 60%, while for US it maybe 99%.
I thought, with smaller market, the efficiency should be higher, since assumptions and predictions made are limited.
how could you arrive at this statement:
ReplyDeletein singapore & with smaller markets, the efficiency is lower. For singapore, it maybe 60%, while for US it maybe 99%.
I thought, with smaller market, the efficiency should be higher, since assumptions and predictions made are limited.
Markets become more efficient when there are more players in the market, i.e. more pple diggin for information.
ReplyDeleteImagine that 10 pple are looking for coins in a big room vs 100 pple. It would be easier for any one of the 10 to find any coins right? If you are in the room with 100 pple, you have only a 1% chance to find a coin.