Can you beat the market?
Market efficiency refers to how quickly and accurately market prices reflect all available information, implying that it’s difficult to consistently outperform the market by using publicly available information. Check here for more information on Efficient Market Hypothesis (EMH).
This theory states that all available information is always reflected in share prices, meaning that stocks trade at fair prices and are never over or undervalued. Supporters of this hypothesis argue that all investors should passively invest in index funds since consistently beating the market is impossible.
Let’s pause here to state that there’s nothing wrong with passive investing! We believe that most investors should be passive investors, faithfully stashing money into low-cost index funds or other retirement accounts.
We also see that even investors in the best-performing stock over 20 years experienced wild draw-downs. Yet, despite the historical record showing frequent draw-downs in individual stocks and major indices, many argue that the efficient market hypothesis persists.
However, research consistently shows that most active investors under perform in the market. And we believe this is due to time, interests, and temperament. In other words, we believe most do-it-yourself active investors fail because they don’t have the:
- Time to properly research their investments;
- Necessary interest level to invest in individual companies;
- Temperament. Far too many investors panic at the worst moments and sell as the market bottoms.
We in general do not believe active investors under perform because the market efficiently prices all information, making it impossible to outperform over the long term. Several instances of long-term track records of active investors, such as Warren Buffett, Peter Lynch, and Chuck Akre, refute this notion.
History, with its many examples of volatility and numerous cases of investors that outperform the market over long periods of time, shows us that the market is not perfectly efficient.
However it is true, that it’s impossible to “beat” the market consistently by using information that everyone else has access to, as any new information is quickly incorporated into stock prices.
Stock market efficiency suggests that it’s tough to consistently “beat” the market through picking individual stocks or trying to time the market because prices reflect all public information. But, skilled investors can still succeed by focusing on long-term fundamentals, and sometimes, market inefficiencies do happen—but those are typically corrected over time.
In the years leading up to the 2008 financial crisis, many investors believed that housing prices would continue to rise indefinitely. Banks, hedge funds, and even individual investors were all convinced that the market was stable, and they invested heavily in mortgage-backed securities. But then, when housing prices started to fall, the entire financial system collapsed.
This event is often cited as an example of market inefficiency—at least in the short term. The assumption was that housing prices would continue to rise, but the underlying risk was not immediately apparent to everyone. It wasn’t until after the crisis that the true depth of the problem became clear. The lesson here is that while the market generally reflects information, there are times when the market mispriced —either by being overly optimistic or overly pessimistic. While the stock market is efficient in the long run, there can be moments when emotions, speculative bubbles, and herd mentality distort prices in the short run.
Story of the Oracle of Omaha: Warren Buffett, known as the “Oracle of Omaha,” is often celebrated as one of the greatest investors in history. But here’s an interesting twist in relation to market efficiency: Buffett himself has often discussed how he doesn’t believe in trying to “beat” the market by timing it or by predicting short-term price movements. Instead, he focuses on investing in companies he believes in and holding onto them for the long term.
For instance, Buffett bought shares in Coca-Cola in 1988. At the time, Coca-Cola was a large, well-established company, and its stock price was already reflecting most of its publicly available information. The key to Buffett’s success wasn’t that he found some secret piece of information no one else had. Rather, it was his ability to understand the company’s fundamentals and its long-term potential. While the market is efficient in terms of pricing current information, Buffett believed that by focusing on businesses with strong prospects and durable competitive advantages, he could still profit over the long term.
Moral of the Story: Even though the stock market is efficient, skilled investors like Buffett can still find success by making sound, long-term investment decisions based on a company’s fundamentals, rather than trying to time short-term price movements.
This is precisely why we preach to focus on business, not the stock!
And while it is certainly no easy feat to beat the market, it is the market’s inefficiencies that give us the opportunity to do so.