Is it better to be an active or passive investor? That is the question.
Efficient Markets Hypothesis is shocking for many investors who hope to beat the market. Are markets that efficient that active investing makes no sense?
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The Three Forms of Efficient Markets Hypothesis
There are three forms of Efficient Market Hypothesis. The first one is the "weak" form. It basically says that all the information is available to investors and that market prices reflect it. In this case, it makes no sense to pick stocks as it will make no difference. This form may be one of the explanations as to why index funds outperform actively managed funds.
Still, in many other situations, superior analysts and traders can outperform the market. So, the "weak" form does not explain it all. There's also a "semi-strong" form of the Efficient Markets Hypothesis. It incorporates the "weak form" plus it says that markets incorporate all public information. This specifically excludes "inside information."
A third one is a "strong" form, which incorporates the other two plus it says that markets incorporate both public and inside information, so no one can benefit from any information. The "strong" form has been disregarded by many as quite unrealistic.
Our take on it is that markets can be efficient at times, but not all the time.
Active versus Passive Investing
Active investing involves investment research in order to find undervalued investments around the world. Active investment manager (or an active individual investor) will seek to beat the market averages. For example, most mutual funds are actively managed.
If you buy a mutual fund, and then sit and do nothing, it is still considered to be an active management of your funds since the mutual fund manager will select investments within the investing mandate of a particular fund. For that service you pay mutual fund fees. The issue is that many fund managers, after collecting the fees, don’t do better than the market average, meaning their efforts don’t produce above-average returns.
Due to that reason, many investors choose index funds that are passively managed (managers basically buy securities that are part of an index). This is a cheaper alternative (fees are lower) and it assumes that markets are efficient.
According to efficient-markets hypothesis, investors can’t consistently achieve above average market returns because all that there is to be known about investments is already reflected in their prices. The hypothesis doesn’t deny that taking higher risks can beat the market. What it says is that it is not possible to beat the market on a risk-adjusted basis.
As far as the hypothesis goes, if breaking news come, the price of an asset adjusts immediately so investors can’t make a profit on it. Researching investments is also futile as whatever information there is, it is already included in the market price.
So, is it really true?
Efficient Markets Hypothesis and Reality
It is true that news, earnings reports, and other factors influence prices of stocks, currencies, bonds, commodities, and other financial instruments. These are reflected in prices. But, not necessarily a judgment that is made at the moment is right. Information has to sink in.
Another thing is that the market as an aggregate of all investors and traders doesn’t pay equal attention to everything. Large cap stocks get more attention than small cap stocks. Some companies aren’t scrutinized as much. So, doing good research can help.
There are also latecomers. If an investor or trader gets in front of these people, profits can be made. But the best way is to get in and out of investments when the smart money does it. (Smart money refers to institutional and other sophisticated investors.) Not only they have access to great research, but also make large trades that move the markets.
As it looks, markets are not 100% efficient. However, efficient markets hypothesis still explains a lot. Most investors can’t beat the market. Only few consistently can do better.
A good analyst or a trader can do well. A superior one makes a fortune.
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