Is the Stock Market Efficient? – Making of a Millionaire

Ben Le Fort
Reasons Why You Need Life Insurance Ben Le

Smart Money

And what it means for your portfolio

Photo by Markus Spiske on Unsplash

The question of whether the stock market is efficient is critical to inform our investment decisions. My favorite definition of what constitutes an efficient market comes from Burton G. Malkiel in his 2003 paper titled “The Efficient Market Hypothesis and Its Critics”. Malkiel defined an efficient market as a market where “prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts”.

To put that in more relatable terms:

· If the stock market is efficient, it’s impossible to “beat the market” and the only sensible way to invest is to buy the whole market through index funds

· If the market is inefficient, it’s possible for active managers to outperform the stock market by picking the “good stocks” and staying away from the “bad stocks”.

The question remains is the stock market efficient?

Research that suggests the stock market is efficient

One of the central questions to determine whether the stock market is efficient is how stock prices move. Do stock prices move randomly or in an identifiable way?

· If the stock market is efficient stock prices will move randomly.

· If the stock market is inefficient stock pickers will be able to identify trends and predict how stock prices will move in the future.

In his 1953 paper titled “The Analysis of Economic Time-Series-Part I: Prices”, David Kendall conducted the first major study on the movement of stock prices. Kendall concluded that there are no predictable patterns and that stock prices move randomly.

This was validation to those who believe the market is efficient.

The Jury is still out on market efficiency

Since Kendall’s paper, there have been many academic papers examining the efficient market hypothesis. There is no consensus in the academic community on whether the market is efficient. Researches have made convincing arguments in favor of and against the efficient market hypothesis.

Even though we do not have a consensus on the efficient market hypothesis, I believe it is important for investors to assume that the market is efficient. There is a very practical reason for this. The only reason market efficiency is important is because it informs our investment philosophy.

The more relevant question for investors is what works better active or passive investing?

  • Actively managed mutual funds have relatively high investment fees that pay for a fund manager to pick stocks.
  • Passively managed index funds have low fees and seek only to track the performance of the stock market

To add value to an investor, stock pickers and active fund manager would have to consistently beat the market by a large enough margin for them to cover their higher fees.

For example, if the stock market returned 10% last year, an actively managed fund with a 2% Management Expense Ratio (MER) would have to have a return greater than 12% to add value to its investors.

The Scorecard: stock-pickers Vs the stock market

The best way to test for market efficiency is to look at the data of how active managers have performed versus the stock market.

Fortunately, Standards & Poor’s collects data on how actively managed funds perform against their benchmark index across the globe.

Over the past 5 years

  • 82% of active fund managers in the U.S underperformed the S&P 500 index.
  • 90% of active fund managers in Canada underperformed the TSX index.
  • 80% of active fund managers in Europe underperformed the S&P Europe 350 index.

There is no country in the world where a significant number of actively managed funds beat their respective index.

There are only two possible explanations for the consistent underperformance of actively managed funds.

1. Active fund managers who pick stocks don’t know what they are doing.

2. The market is reasonably efficient.

I do believe the fund managers are intelligent people that are very knowledgeable about financial markets.

So, I am inclined to believe that markets are reasonably efficient. This means that picking stocks and “timing the market” is next to impossible. If the market is efficient, stock prices are valued correctly, and their prices change randomly. Meaning there is no opportunity for stock-pickers to add value or justify their higher fees.

In any given year, a handful of actively managed funds will beat the market. The question becomes why did they beat the market? Was it due to their stock-picking skills or luck?

Odds are it was luck. Even if it was due to their skill, you as an investor have an even bigger problem. How do you choose the fund manager who will beat the market before they beat the market?

By investing in an actively managed fund, you are opening yourself up to additional risk.

  • Anyone who invests in the stock market is taking on “investment risk”.
  • When you invest in actively managed funds you are also taking on the additional risk that your fund manager will pick the wrong stocks and underperform the market.
  • You are compensated for investment risk through higher expected returns compared to safe assets.
  • You are NOT compensated for the risk that your fund manager picks the wrong stocks.
  • I just showed that 82% of active managers fail to beat the market. When choosing an active fund, you are taking additional investment risk for a lower expected return.

I’m all for taking on more risk, but only if that risk comes with higher expected investment returns. Taking on additional risk without a higher expected return is not a logical decision.

The takeaway

While the stock market is probably not “perfectly efficient”, the academic literature and historical data would suggest that markets likely “reasonably efficient”. This is backed up by the fact that actively managed funds consistently underperform the market.

If we believe markets to be at least somewhat efficient, the most sensible investment decision is to invest in low-cost passive index funds.

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