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?”