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 (strategy 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 off. 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 also 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 at least once a year to restore the original proportion of funds. This investing method requires 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 have been very satisfied with index funds.

It did not surprise many when Warren Buffett, while recently hosting a group of business students 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 (known as 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, where 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 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, and so there is 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?”

I expected some sprinkling of mathematical expressions here and there, but to my surprise, there is none! In Paulos’s own words, he wanted to use “vignettes and stories rather than formulas and equations” to “explore the basic conceptual mathematics of the market”.

I enjoyed his engaging style of writing, and the “cloyingly personal account of how I lost my shirt” with WorldCom stocks was a first. I mean, most investing books come across as an impersonal collection of dos and don’ts, as though the author is too smart to do such dumb thing as buying telecom stocks in the middle of dotcom bust.

Most of the material presented here is already covered in other, and more famous, books, so there is little here for a knowledgeable investor, at least on the practical side of investing. (For those of you looking for hands-on advice, I would suggest Burton Malkiel’s classic A Random Walk down Wall Street. And if you are a total novice, Andrew Tobias’ The Only Investment Guide You’ll Ever Need is a great first read, as it was for me.) This book does not offer any financial advice, such as how to construct a high-yield portfolio or pick the hottest stocks, what Paulos calls “financial pornography”.

Like most academicians talking about investing, the bias here is strongly in favor of efficient market hypothesis, rather than fundamental analysis (the first one gave us Nobel Laureates, the second one gave us Warren Buffett). But Paulos, like Malkiel in later editions of his book, acknowledges the merit of the latter, at least over short time scales. (If the market is really that efficient, how does one explain bubbles and bursts?)

The problem is though, after adding up the time and effort spent researching the fundamental attributes of a company, and subtracting transaction costs and other fees from your earnings, you do not gain much over the “set-it-and-forget-it” armchair investors who rely on market efficiency and put their faith in index funds.

The book gets really interesting in the last two chapters, where Paulos discusses such technicalities as complexity, chaos, power laws, fractality and paradox, all using simple language. I particularly liked his arguments proving “if efficient market hypothesis is true, most investors will not believe it, and if it is false, most will believe it”.

This does make sense: if most investors believe market efficiency to be true and do not react to new developments (an efficient market will already have incorporated them into prevailing stock prices), the few non-believers will exploit these developments and to them the market will respond slowly, thus falsifying the hypothesis. You can turn the argument around to prove the other half of the paradox too. Paulos thinks the efficient market hypothesis is “neither necessarily true nor necessarily false”.

To wrap up, I recommend this book as a general reading to savvy and novice investors alike – the former ones will enjoy the honesty of personal narratives (besides the easy intellectuality that permeates through the book), and there is enough stuff in here to teach smart investing to the latter ones.