efficient market hypothesis

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.