EMT or FA – which one is “correct”?

Interestingly, even though Buffett began his session with the Wharton students by criticizing the “misguided” EMT, he later advised average “non-professional” investors to buy-and-hold index funds (the strategy based on EMT), instead of trying to pick value stocks (the motto of FA) because “they are not going to be able to pick the right price and the right time”.

Coming from the Oracle of Omaha, this seeming contradiction can throw you. But, what he is really saying is that both these investing strategies are in fact correct, but they apply to two quite different types of investors. Value investing is the correct approach for professional investors, whereas portfolio diversification (with index funds) is correct for the armchair kinds.

A savvy investor, after finding a potentially undervalued stock, must do extensive study of the company (financial statements, annual reports, latest news etc.) before he can be confident enough to buy the stock. A value investor must execute frequent trading to replace old overvalued stocks in his portfolio with new undervalued ones.

By contrast, an average investor buys and holds a bunch of index funds from different industry sectors to diversify his portfolio (against market risks), and rebalances the portfolio once a year to restore the original proportion of funds. This investing method demands very little time and effort from the investor.

If both are correct, who gets more?

A simple portfolio, made up of a single index fund that tracks a broad market index such as the S&P 500 Index, experiences the usual market fluctuations over short times. Over long time, though, the portfolio guarantees the market return (minus the small operating cost of managing the fund), which was more than 10% over several past decades.

A value investor’s portfolio, on the other hand, is expected to grow (despite short-term fluctuations driven by market events) until the undervalued stocks are priced “right”. The probability of a higher-than-market return increases with the expertise of the investor, and with the time and effort spent in researching the stock’s prospect.

Simply put, an average investor with a portfolio of index funds will certainly get at least the market return over long term, whereas a professional investor with his value stocks has only a chance of achieving a higher-than-market return. (And unless the difference is substantial, high costs and taxes incurred from frequent trading can eat into the return, often pulling it down below the market return.)

There is overwhelming evidence available that achieving such higher-than-market returns on a consistent basis is an extremely rare phenomenon indeed, because no one can “pick the right price and the right time” year after year after year (if you want proof, I suggest reading Burton Malkiel’s classic A Random Walk Down Wall Street). As for me, I prefer certainty over chance, and I am very happy with index funds.

69-year old Earl Crawley, while making $20,000 a year as a parking-lot attendant, still amassed over $500,000 in investment asset. His secret? Two, in fact. The first is his good old habit of saving every “nickel and dime”, and the second is his lack of investing knowledge, summed up in his quote that I borrowed above.

Saving and investing, in that order (you must save to invest), are the two essentials for building wealth slow and steady. Saving is common sense, and to people like Earl, almost an instinct. Investing, by contrast, requires some learning. But, knowledge plays a self-limiting role in our investing decision, which in turn affects investing performance.

The two fundamental things of investing are where to invest and how to invest. That is, the assets that make up our portfolio, and the proportions in which these assets are allocated. Unfortunately, there are as many different answers to these two questions, as there are books written about them. The more we know, the more confusing they get, and even drawing up the simplest asset mix can become a difficult task.

Keep it simple.

Solution? Keep it simple. Beyond the basics, knowing more does not help much. It is a bit like the picture here. At first, the return of your investment (solid blue graph) goes up with your knowledge level, but after you are past the basics, your return hits a “saturation point”. After this point, more knowledge causes information overload, and the payoff does not show a commensurate increase; in fact, the return can even decrease, depending on the specifics of your portfolio (in investing, more knowledge is not necessarily better knowledge).

Know the basics

What are these investing basics? There are four steps to it:

1. Depending on your risk tolerance, build a portfolio with the right proportions of risk-free (money market, treasury bills etc.) and risky (stocks and bonds) assets.
2. For your risky assets choose among those that do not move in lockstep with each other (for example, stocks+bonds, domestic+foreign stocks, etc). This way, you can spread out the risk of market downturns, and reduce its impact on the return of your portfolio.
3. Build your portfolio with manageable number of assets. Adding too many stocks and mutual funds is an example of information overload; if you do not understand them, you do not know their return potential, and your portfolio return itself can suffer.
4. Once you set up your portfolio, hold on to it. Do not tweak your asset mix each time the market does something unexpected. As I said in an earlier post, there is no get-rich-quick scheme in investing; a “buy and hold” strategy is the only way to smooth out short-term market fluctuations, and gain from the long-term economic growth.

Again, keep it simple. Earl does exactly that. He is open to suggestions and stock tips, but uses his own common sense and gut instinct to make decisions on which stock to buy. He is a self-made investor. Why can’t we all be like him?

1. In order to run for 15 years, or 225,000 miles (with the national average of 15,000 miles a year), you must buy a new car and maintain it regularly.
2. Many new cars, even with proper maintenance, do not survive 200,000 miles. The “good bets”, according to the article, are SUVs, pick-up trucks, and hybrids. This leaves out the significant segment of standard mid-sized sedans, a preferred choice of many average American families.
3. The price comparison is made with a Honda Civic EX bought every 5 years, accounting for depreciation, insurance and maintenance cost.

This is a great advice for those who do heavy driving. In an earlier post, I suggested a similar “buy and hold” strategy for new car buyers. But my main suggestion there is to get a reliable used car every 5 years (or after it dies on you, whichever is later). This is for those who have a relatively short time horizon with the same car, mainly because of changed circumstances in family, job and such other that cannot always be foreseen.

In the long run, investing is not about markets at all. Investing is about enjoying the returns earned by businesses. And the stock market is nothing but a giant distraction in that quest to acquire returns that business earns.

Without telling anything new, this quote still reminds us of the big picture of investing: a buy-and-hold strategy for the long haul is the only way to escape the ravages of market swings, and to benefit from the slowly (and surely) growing economy. I recommend reading the entire interview.