If the Market Is So Darn Efficient, Then Why Is this Blog Free? Wait, Don’t Answer That!

Megan McArdle, my favorite libertarian blogstress, has some thoughts about Michael Lewis’ Portfolio article and Efficient Market Hypothesis (see also here and here). Megan is a great blogger and I read her every day.
I don’t want to get too deep in the weeds on this topic but I’m an EMH skeptic and I want to explain why. My main beef with it is that EMH suffers from theoretical overreach.
OK class, let’s remember our scientific method. A theory is a logical explanation for natural phenomena. Well, EMH explains a whole lot, but there are still some holes. The wholes aren’t big, mind you, but they’re definitely there and can’t be ignored.
Maybe some day, someone will come along with a better explanation for the market and those holes. I hope that day comes soon, but until then, EMH is the best we got.
To me, the most significant hole is that value stocks have consistently outperformed the market and they’ve done it with less volatility. The data here is unambiguous. It goes back 80 years and it’s clear as a bell. Again, we’re not talking about a huge difference, but it’s there. There are others (Yahoo at $25?), but that’s the cleanest.
Let me be clear: I think the market is very efficient, but the market can be consistently beaten. It’s not luck. It’s just very, very, very, very hard.
As a practical matter, there’s a lot to be said for index funds. From my experience of investor behavior, more people ought to own them.
It’s interesting that EMH defenders always say that the market can’t be beaten. They rarely defend the other half—the market can’t beat you. What can I say? I know people who have done a great amount of empirical research on this front and their results are, sadly, quite compelling.
One final note: Please feel free to ignore the fact that this is a discussion of efficient markets taking place on free blog sites.
Update: Megan has more today:

I am being assailed by people pointing out that Berkshire Hathaway has done spectacularly, and therefore this EMH stuff is a bunch of hooey. I could point out that if you’d had a million guys flipping coins repeatedly for a year, at least one of them would have come up with a massive streak of heads. Even if you paid him $1mm for each heads flip, this would not actually be attributable to his awesome coin-flipping skill. Indeed, you’d have at least one cluster of guys who’d done well…perhaps fellows who’d gone to Harvard together, or people who’d all studied “Value Coin Flipping” under a master. There would be other outliers, and other groups of people who’d studied “Fundamentalist Coin Flipping” or “The Vincenzi Flipping Technique” who would not have done well. But no one would be looking to them for advice, so you would never have heard of them, and it would seem like a minor miracle that this guy, this technique had just produced such amazingly outsized returns.

If superior performance were solely due to luck, wouldn’t we see more “successful” coin-flippers attribute their returns to arbitrary sounding strategies? You know, investing by astrology, the weather or charts patterns. Hey, if it’s all luck so the strategy shouldn’t matter.
But that’s not what we see. If you go down the list of people who have amassed great long-term track records, each one credits Graham and Dodd style value investing. There’s Peter Lynch. There was Bill Ruane who met Buffett decades ago at a Graham conference. There are the guys who Leucadia National who have done even better than Berkshire. They espouse the exact same philosophy. The guys at Danaher. The Tisch brothers. Eddie Lampert. The list goes on and on.
As far as I know, no technical analyst is on the Forbes 400 but there are lots of value investors.

Posted by on December 12th, 2007 at 11:57 am


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