Tuesday, February 5, 2013

Market Efficiency and Individual Investors

            There is an old joke about two hikers who come across a bear.  One turns to run and the other says, “It’s no use, people can’t outrun bears.”  To which the first replies, “I don’t have to outrun the bear.  I just have to outrun you.”  This story has an application to investing and the concept of market efficiency.

To review, an efficient market is one in which market prices reflect all publicly available information.  In such a market, it makes no sense for an investor, particularly an individual investor, to try to beat the market by finding under- or over-valued securities because there aren’t any.  It should come as no surprise, therefore, that advocates of active investment management are always on the lookout for evidence of market inefficiency.  Quite frankly, there is a good deal of such evidence in published academic research.  There are even papers that prove, from a theoretical perspective, that stock markets can never be fully efficient.  So, does that evidence imply that investors ought to try to beat the market?

The joke about the bear serves as a warning.  To make active trading a folly for an individual investor, it is not necessary that the market be fully efficient, it is just necessary that the market processes information more efficiently than the individual who is trying to beat it.  (Remember that investors trying to beat the market can also run up significant transaction costs.)  And that is very likely to be the case.  The market may experience bouts of irrationality and over-reaction, but individuals are far more likely to fall prey to such foibles.  In short, the market may not be perfect, but it is almost certainly more perfect than you are.

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