Debunking the efficient market myth I

Modern finance has very much based itself on a concept that I believe is quite fallacious. What I am referring to here, is the notion of market efficiency. The concept holds that in a semi-strong effcient market, the "efficient" prices are assumed to reflect fully and realistically all publicly available information. It holds that unless one gains material non-public information, there is no way of unearthing genuine bargains, since the favourable circumstances existing are already reflected in the price of the stock.

Admittedly, there is a certain element of truth in it. Very much like in a pari-mutuel betting system, the odds of a favourable gain has to be weighed against the extent of gains that is already reflected in the price. However, a half-truth doesn't serve the investor well at all.

The efficient market theory grew out of the school of random walkers. These people found out that it was difficult to identify trading strategies that worked well enough after transaction costs over along periods of time relative to the risks undertaken. These trading strategies work well some of the time and fail in others. It becomes very much like flipping a coin to decide whether to buy a stock. I don't disagree with this.

Once again, I set out disqualifiers, because there are always exceptions to the rule but not many. These include high frequnecy alogorithm traders such as Renaissance Technologies and other quantitative funds. This method is gaining alot of attention and competition from large banks and hedge funds. I believe it would become a matter of time before the market starts to arbitrage away these huge profits.

Though I know quite a bit about program trading, I do not know enough to give advices. What I am proposing here is the best method of investing not trading. One should be seeking investment opportunities with unusual prospects over the long term and avoid those that are of poor quality. This would be the central tenet to the proposal that is prescribed here.

I do not believe the markets are efficient in this approach because it is unpopular and many investors have a tendency to learn the wrong lessons. At first glance, it might seem amateurish, inexperienced and sometimes downright dumb to the untrained eye. It is safe to say to assume if you knew something was wrong, you wouldn't believe it in the first place.

Most humans, hate self-questioning and prefer to spend their time convincing themselves and others their beliefs are right. These beliefs persist, particularly when they make sense intuitively and even more so when others around agree to it. To determine the efficiency or the lack of thereof with the investment approach, the investor will have to look at whether approach are scientifically sound and relatively unpopular. The method must not be generally accepted because those that are well accepted do not produce the required results. Ironically, this reflects an unfathomable idea, "Precisely because nobody ever think is going to work, which is why it is going to work wonders."

Be particularly wary of making a decision simply because of something you know others agree with. The reasons why we hold certain false belief is because 1) They make common sense and one is typically not prone to question his common sense. 2) People around you tend to agree with you and one do not have an inclination to challenge widely held views.

By and large, those who have accepted and been influenced by the efficient market theory fall in into 2 groups. One is students, who have had a minimum exposure to practical experience. The otherm strangely enoughm is those managers of large institutional funds. The private investor by and large has paid relatively little attention to this theory.

Also, a large number of studies have shown that variation in portfolio values are 90% caused by asset allocation between the different asset classes. Implying that the greatest gains or losses are to be made by moving in and out of markets. However, it is of my viewpoint that timing the market is extremely diffiicult, simply because you have to get several things right. One will have to select the right stocks, to make sure it can withstand a severe crisis. You have to make sure that the price is right and you are not catching a falling knife. You also will have to get out at a good price with the timing right the next time you sell out.

What I am proposing here, is to choose extremely carefully the stocks you are going to buy. Buy them at a relatively fair price. Then put your hands under your butt for the next few decades, a "buy and sit on your butt" approach to investing. Then you just wait. That is all to it.

It can be easily observed that in a portfolio of a large number of stocks, be it a mutual fund or an index. Countless empirical evidences show that a "small" number of stocks actually drives a large proportion of changes of value within any portfolio. Over a couple of decades, these gains in value can become extremely substantial. The ultimate question then begets "Is it possible for investors to identify them?" My answer is "Yes, you can. However, it is not easy to find such opportunites at all."