by Philip Pilkington
The Efficient Markets Hypothesis (EMH) is wrong. It has been proved wrong. Do you think you’ve heard this before? You likely have, but the proof that you’ve heard that the EMH is wrong probably has not done the damage that you thought it had.
When I studied the EMH for my dissertation I noticed that many had thought that the financial crisis of 2008 had proved the EMH wrong. In one way this was true. Investigations undertaken by the authorities had uncovered that people within many markets were actively misleading the public about the underlying value of securities.
After being told that a security was not structured properly an S&P official said that they would rate it regardless. “We rate every deal. It could be structured by cows and we would rate it.” If the EMH says that markets price in risk perfectly then the markets were not operating in the manner the EMH predicted in the run-up to 2008.
Nevertheless, this mattered little for the other claim made by the EMH proponents. The EMH proponents said that you cannot beat the market consistently. Because all information is already priced in then any gains you make over the market will only be temporary. If you beat the market this year, the chance that you beat the market next year will be extremely low. If you beat the market both this year and next year then the chance that you will beat the market the year after will be lower still. Using this reasoning you will, in the long-run, be completely unable to beat the market.
I found this reasoning terribly troubling. First of all, just because most people cannot beat the market does not mean that the EMH is correct. A number of other hypotheses could also be correct. For example, the Post-Keynesian proposition that the future is inherently uncertain and thus that predictive techniques of complex market dynamics will likely fail could also be confirmed by the same observation.
Secondly, the proposition struck me as being tautological. Who was the ‘you’ in the statement ‘you cannot beat the market’? It seemed to me to be the idea of an ‘average investor’. But, as everyone knows, ‘the market’ is simply the outcome of the average decisions of all investors taken together. Thus, ‘the market’ is actually the expression of ‘the average investor’. The two terms — ‘the market’ and ‘the average investor’ — are actually synonyms. So, the statement ‘the average investor cannot beat the market’ could just as easily be read as ‘the market cannot beat the market’ or, alternatively, ‘the average investor cannot beat the average investor’. This struck me as being a purely tautological and highly problematic approach to studying markets. It appeared that EMH proponents were confusing the idea of the ‘average investor’ with any given ‘particular investor’.
Thirdly, tied to the second point and most importantly, it appeared to me that many people do indeed consistently beat the market. The probability of someone like Warren Buffett existing seemed to me, from an EMH perspective, entirely implausible. But then I found something even more unlikely: John Maynard Keynes had, in the 1930s, effectively tracked Warren Buffett’s stock market performance. In the graph below you can see Keynes’ investments plotted against both Buffett’s and the market return in his own time.
As John Authers wrote in his article ‘Keynes Stands Tall Among Investors‘ when he compares Keynes with Buffett:
What of Warren Buffett, the world’s best-regarded investor? The chart shows how the portfolio of Berkshire Hathaway, his main investment vehicle, has performed over the past 22 years – and the King’s endowment under Keynes did better. Had we chosen the first 22 years of Buffett’s tenure, when his portfolio was smaller, making it easier to outperform, Buffett would be ahead. But Keynes’ record places him in exalted company.
Now, this seemed to me beyond a coincidence. Maybe you could make the case that Buffett was an anomaly, an outlier on the probability map, but Keynes? This seemed doubtful. Was it merely a coincidence that one of the greatest and most famous economists of the 20th century — one who emphasised the unpredictability of the future and the irrationality of the financial markets — was also able to beat the odds? This seemed highly improbable. But the plot thickened as I pursued this further: it seemed that Keynes had used a very similar investment strategy to Buffett. While in the 1920s he had tried to play some silly mathematical games he had lagged the market. But when he switched to the strategy that Buffett uses he saw his gains soar. Authers writes:
His performance lagged the market in the 1920s, when he used an elaborate economic model to time the market. It did not work, and he failed to spot the Great Crash coming. He admitted that this approach “needs phenomenal skill to make much out of it”. So he switched to picking stocks. Like Buffett, he said he became ever more convinced that “the right method in investment is to put fairly large sums into enterprises one thinks one knows something about”. His results speak for themselves.
Could this all be coincidence? It seemed to me that it probably was not. And then I stumbled on a famous 1984 article by Warren Buffett himself entitled ‘The Superinvestors of Graham-and-Doddsville‘. In the article Buffett discussed a group of nine investors who had substantially outperformed the market in a 20 year period. He accepted that these could all be simple probabilistic anomalies — black swans, as it were — but he noted one important point: they all came from the same school of investing.
Now this did not mean that they all bought the same assets. If they had that would explain the anomaly. But they did not. They all had different strategies and they bought different assets. But they all followed the same philosophy.
As Buffett said in the piece: if there were 1,500 cases of a rare cancer in the US and 400 of them were in a small mining town in Montana good scientists would probably go to the mining town and check the water. Economists do not do this type of research, however, which is what critical realists and other critics of econometric/probabilistic approaches (present writer included) always complain about. But if they did do true scientific research Buffett’s article would interest them greatly.
Looked at from anything resembling a scientific approach it is quite obvious that Buffett’s article proves the EMH completely wrong. It is also interesting that the investment strategy that Buffett, Keynes and the nine other investors discussed in Buffett’s article runs exactly contrary to the EMH assumption of information being priced into markets at all times. Indeed, their investment strategy rests on the idea that market prices often diverge substantially and for long periods of time from the underlying value of the assets.
So, what have the economists said in response? Nothing. Not being scientists but rather moralists and soothsayers they simply avoid contrary evidence when it is presented to them. As the investor Seth Klarman wrote in his book Margin of Safety:
Buffett’s argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what was refuted in practice. (p199)
Economists and business schools continue to teach the EMH, of course. It continues to give off the mystique that markets somehow get the price ‘right’. It does so by being vague to the point of meaninglessness in many cases. But when it does manage to say something concrete and make a claim that can be falsified, it fails. And when it fails its proponents simply ignore the overwhelming evidence to the contrary. This is not science. It is ideology.