efficient market hypothesis

Two Economists

© Can Stock Photo / skaron

The story goes like this. Two economists are walking down the street. One says, “Look! A $20 bill, just lying there!” and reaches to pick it up. The other says, “You fool! If that was really a $20 bill, somebody would have picked it up already.”

The underpinnings of this joke might be what is called the Efficient Markets Hypothesis, or EMH. It holds that all available information is already in the price of every security, so it is not possible to ‘beat the market.’ Related notions include the idea that investment selection does not matter, only the asset class or investment allocation.

Of course, our experience tells us that at times, certain investments do get mispriced. Condos in Las Vegas in 2007, tech stocks during the dot-com era, oil at $140 per barrel in 2008: all of these things seem to be examples of when the market was not efficient at all.

At these times, consensus expectations drifted far from the unfolding reality. “You can’t lose money in real estate” and “We’re in a new era, tech stock valuations don’t matter” and “Oil will never trade below $100 again” were the refrains of those faulty expectations. You may remember them.

Of course, we believe that the crowd can be wrong. That space between consensus expectations and the unfolding reality is where profit potential lives. One of our jobs is to try to find those exploitable anomalies and invest in them. Another is to go against the crowd when we believe it is wrong.

The simple rule, ‘never join a stampede in the markets,’ is one way we express this.

As a consequence, looking at the world with our own eyes, doing our own research, finding our own conclusions, this is what we do at 228 Main. It takes some courage to go against the crowd, to take unpopular actions, to stick with our strategies even when they require more patience than we had planned on. You and we are in this together: without your persistence, we could not do what we do over the long haul.

Hopefully from time to time we will find those $20 bills that others do not believe in.

Clients, if you would like to talk about this or anything else, please email us or call.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Expecting the Expected

© www.canstockphoto.com | trekandshoot

In our quest to make sense of the world, one recurring theme is the potential gap between expectations and reality. We humans do one thing very well: we love to take things too far. Thus we have bubbles, manias, and fads, unrealistic expectations and the Kardashians.

When there is a universal expectation of something, the expectation can be said to be “already in the price.” If the expectation comes to pass, there will be little impact on the market. If reality unfolds differently, however, the market will move.

For example, several years ago when all the Washington news was about the “fiscal cliff,” the country needed Congress to do the right thing to avoid catastrophe. Congress ranks in public estimation somewhere lower than a snake’s belly, so the consensus expectation was for catastrophe. The markets performed poorly as a result.

But as the deadline approached, it seemed evident to us that expectations were SO low, there was very little chance that Congress could perform worse than expected. We expected Congress to produce a catastrophe, and that expectation was “already in the price.” If Congress either did as expected or better, the market might remain steady or go up. Since Congress could hardly do worse than expected, we felt that actual risk was lower than most others perceived.

This understanding enabled us to stay the course amidst great uncertainty, to our benefit.

One of the most-talked about issues today is whether or when the Federal Reserve Board will raise interest rates. We all know that this will happen sooner or later; this knowledge is presumably already in the market. Hence, we see little advantage in fussing over the probabilities.

When something happens that everyone knows was going to happen, there usually is not a big effect on the market. So we spend our time trying to find unexpected opportunities instead of expected problems.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Data vs. Wisdom

© Can Stock Photo Inc. / kentohIf you are an avid news reader, you are subject to a flood of information about the world. We read about everything from wars to weather, science, scandals, politics and gossip. This adds up to a wealth of data available to an informed investor to make decisions with.

Here’s the problem: most of it is useless. When you see a headline that seems to affect your investment choices, everyone else is seeing the same thing—and is already factoring that news into the stock price, good or bad. The entire vast store of public knowledge is of no use to us when the market condenses and distills all of that data into a single measure: the company’s publicly traded stock price.

Some economists go one step further and say that investment picking is fundamentally useless, because markets are so good at determining the fair price of an asset that it is impossible to find an undervalued asset. This is called the “efficient market hypothesis.”

However, we can see a flaw in this hypothesis: it rests on the assumption that human beings are rational. We’ve already noted that people are irrationally loss averse and prone to exaggerate market swings. When the stock market fell by 50% from June 2008 to March 2009, it wasn’t because half of our collective corporate wealth magically went up in smoke. We were seeing irrational market swings in action.

It is virtually impossible to beat the market using all of the data that goes into the market in the first place. Instead, we believe we can achieve positive results by using simple fundamental principles to avoid irrational stampedes and find undervalued bargains.

Investing involves risk including loss of principal. No strategy assures success or protects against loss.