By LARRY SWEDROE
The most common of all follies is to believe passionately in the palpably not true.
H. L. Mencken
There is an old story about a financial economist who also happened to be a passionate defender of the efficient markets hypothesis (EMH). He was walking down the street with a friend. The friend stops and says, “Look, there is a $20 bill on the ground.” The economist turns and says, “Can’t be. If there were a $20 bill on the ground, somebody would have already picked it up.”
This joke is told by those who believe that the markets are inefficient and that investors can thus outperform the market by exploiting mispricings — finding an undervalued stock instead of a $20 bill. It is actually a misleading analogy to the EMH. The following version is a much better one.
A more accurate version
A financial economist, and passionate defender of the EMH, was walking down the street with a friend. The friend stops and says, “Look, there is a $20 bill on the ground.”
The economist turns and says, “Boy, this must be our lucky day! Better pick that up quick because the market is so efficient it won’t be there for long. Finding a $20 bill lying around happens so infrequently that it would be foolish to spend our time searching for more of them. Certainly, after assigning a value to the time spent in the effort, an ‘investment’ in trying to find money lying on the street just waiting to be picked up would be a poor one. I am certainly not aware of anyone who has achieved their wealth by ‘mining’ beaches with metal detectors.”
When he had finished, they both looked down and the $20 bill was gone!
The Hollywood version
There is also what might be called the Hollywood version of this story. A financial economist, and passionate defender of the EMH, was walking down the street with a friend. The friend stops and says, “Look, there is a $20 bill on the ground.”
The economist turns and says, “Can’t be. If there were a $20 bill on the ground, somebody would have already picked it up.” The friend bends down and picks up the $20 bill and dashes off. He then decides that this is an easy way to make a living. He abandons his job and begins to search the world for $20 bills lying on the ground waiting to be picked up.
A year later the economist is walking down the same street and sees his long-lost friend lying on the sidewalk wearing torn and filthy clothing. Appalled to see the dishevelled state into which his friend had sunk, he rushes over to find out what had happened. The friend tells that him that he never again found another $20 bill lying on the ground.
The costs exceed the benefits
Those that tell the first version of the story fail to understand that an efficient market doesn’t mean there cannot be a $20 bill lying around. Instead, it means that it is so unlikely you will find one that it does not pay to go looking for them — the costs of the effort would likely exceed the benefits.
In addition, if it became known that there were lots of $20 bills to be found in a certain area, everyone would be there competing to find them. That reduces the likelihood of achieving an appropriate “return on investment”.
Inefficiencies eventually correct themselves
The analogy to the EMH is that it is not impossible to uncover an anomaly (i.e. that $20 bill lying on the ground) that can be exploited (being able to buy a stock that is somehow undervalued by the market, or short one that is overvalued).
Instead, one of the fundamental tenets of the EMH is that in a competitive financial environment, successful trading strategies self-destruct because they are self-limiting. In other words, when they are discovered, they are eliminated by the very act of exploiting the strategy.
Andrew Lo’s adaptive markets hypothesis acknowledges that while the EMH may not necessarily hold in the short run, it does predict that inefficiencies will self-correct over time as arbitrageurs exploit them post-publication. Thus, financial markets trend toward efficiency in the long run.
EMH thrives on criticism
In their 1996 paper The Efficient Market Theory Thrives on Criticism, economics professors Dwight Lee and James Verbrugge of the University of Georgia explained the power of the efficient markets theory in the following manner:
“The efficient market theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear efficient market anomaly is discovered, the behaviour (or lack of behaviour) that gives rise to it will tend to be eliminated by competition among investors for higher returns.
“[For example,] if stock prices are found to follow predictable seasonal patterns unrelated to financially relevant considerations, this knowledge will elicit responses that have the effect of eliminating the very patterns they were designed to exploit.
“The implication here is rather striking. The more empirical flaws that are discovered in the efficient market theory, the more robust the theory becomes. [In effect,] those who do the most to ensure that the efficient market theory remains fundamental to our understanding of financial economics are not its intellectual defenders, but those mounting the most serious empirical assault against it.”
The “January effect”
The following example demonstrates how the efficiency of markets rapidly eliminates opportunities for abnormal profits.
Imagine that an investor discovered that small-cap stocks historically outperformed the market in January (there is a $20 bill lying on the ground waiting to be picked up). To take advantage of this anomaly, that investor would have to buy small-cap stocks at the end of December, prior to the period of outperformance. After achieving some success with this strategy, other investors would take note; with the large dollars at stake, Wall Street is quick to copy successful strategies. An academic paper might even be published.
Since the effect is now known by more than just the original discoverer of the anomaly, in order to generate abnormal profits, one would have to buy before others did. Now prices start to rise in November. But the next group of investors, recognising this was going to happen, would have to buy even earlier.
As you can see, the very act of exploiting an anomaly has the effect of making it disappear, making the market more efficient. It is worth noting that if there ever was a January effect in small-cap stocks that could be exploited after the costs of the effort, it no longer exists.
The moral of the tale
The moral of this tale is that while the market may not be perfectly efficient (i.e. it is possible to find a $20 bill waiting to be picked up), the winning investment strategy is to behave as if it were.
Consider carefully these words from Richard Roll, financial economist and principal of the portfolio management firm Roll and Ross Asset Management:
“I have personally tried to invest money, my client’s and my own, in every single anomaly and predictive result that academics have dreamed up. And I have yet to make a nickel on any of these supposed market inefficiencies.
“An inefficiency ought to be an exploitable opportunity. If there’s nothing investors can exploit in a systematic way, time in and time out, then it’s very hard to say that information is not being properly incorporated into stock prices.
“Real money investment strategies don’t produce the results that academic papers say they should.”
The moral of this story is that investors who accept the EMH as fundamental to their investment strategy don’t have to spend their time searching for the very few $20 bills lying on the ground.
Instead, they earn market returns based on the amount of risk they are willing to accept (based on their exposure to common factors) and incur less expenses.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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