(This post is a part of the series Basics of Finance and Investing.)

It did not surprise anyone when Warren Buffett, while recently hosting a group of business students from the University of Pennsylvania’s Wharton School (his alma mater) for a two-hour question-answer session, began by pointing out the folly of the efficient market theory (EMT). After all, his objection to EMT is as legendary as his support for fundamental analysis (FA), as the foundation for smart investing.

But first thing first: what is EMT, and what indeed is FA? (These are my short-hands, by the way.)

Efficient Market Theory (EMT)

EMT holds that the (stock) market is so efficient in absorbing the latest developments in the industry (company merger, major product launch, corporate scandal etc.) that the stock prices almost instantly reflect these developments. Thus, there is very little time available to an average investor to act on such “inside information”, before it becomes common knowledge so everyone does the same (thereby quickly driving stock prices up or down). In other words, because such developments are unpredictable, stock prices in turn cannot be predicted and they execute a random walk down Wall Street.

The investing strategy based on EMT is known as portfolio diversification, where the investors buy and hold a range of stock (and bond) funds indexed to broad segments of the financial market (also called index mutual funds). Because the prices of individual securities in a fund do not move in lockstep with each other, the portfolio achieves “diversification” by spreading the risk of asset downturns (dip in one security is compensated by rise in another).

Fundamental Analysis (FA)

FA holds the contrasting view that although unpredictable market events drive the stock prices over short times (as in EMT), there is a fundamental (or intrinsic) value of every stock that can be determined by analyzing the company papers (financial statements, annual reports etc.) and other available information on its management policy, competitive edge and so on. The stock price eventually catches up with its value (which is predictable), and the investor can benefit by trading the mispriced stock and waiting till it is “corrected” by the market.

The investing strategy based on FA is known as value investing, where the investor looks to buy undervalued stocks of otherwise healthy companies. Such a portfolio is expected to grow with time despite short-term fluctuations (so no need for diversification). But, because a company does not generally stay healthy forever (management changes, economy takes a hit, and so on), a value investor must tune his portfolio time to time by selling old overvalued stocks and buying new undervalued ones.

Go on to “Part II - Which one of them is correct?”

See related posts:

1. Efficient Market Theory vs. Fundamental Analysis - Part II
2. Buffett on the best investment idea
3. "A Mathematician Plays the Stock Market" - a review
4. Basics of Finance and Investing
5. "The Smartest Investment Book You’ll Ever Read" - a review