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  • Writer's pictureJohn Brandy

Efficient Market Theory

Updated: Apr 5

What's our listener anchor for this week?


Their Lighthouse, right?


Kuf. Their one-sentence takeaway.


Oh, you mean that bit that goes at the top of the show notes?


Yes, that bit. That sentence. That, you know, thing.




We're taught to distrust financial people. Many books have been written about this, but what we do here is not only expose the thing but explain, from a former broker perspective, why it happened - what's the conflict of interest. But that doesn't mean that Efficient Market Theory is true.


I didn't mean to just read it again.


Okay, sure, but it is important, and plus, you know how I advocate practice and repetition.

Throwing some wild thoughts here about efficient market theory...




Wait a sec...how do you say wild and efficient in the same sentence?


Because DT. I'm making a point.


Which is what?


That it's possible to be wild on purpose and thus also be efficient.

Nothing to say back to that one, huh, oh speechless one?

In that case, I'll go on with my explanation.

Efficient market theory is a concept supported by and expounded in a book called A Random Walk Down Wall Street.


Which is a fundamental analysis of the whole thing, right?


Sort of. The idea is that everyone has all of the relevant information on which to make a decision, and they have it at roughly the same time as everyone else.


When does the SIMPLE part come in?


That's pretty simple right there. You have something and I have that same something too.


If this is so simple, why do we need a book to explain it?


Because a book can be a stream of income.


An MSI?


Yep. But that's a different show.

The book, by Burton G. Malkiel, came out originally in 1973. I first read what was the 8th edition in about 2007, during the financial crisis. This is one of a few different pieces of finance literature which came out around then.


That alone says it stood the test of time.


Sort of, except it's had some criticism which we'll get to later.

I'm conflicted about this a little bit because the idea is highly connected to a well-read, well-researched, and thoughtful economics professor at the University of Chicago named Eugene F. Fama. And for those who don't know, the Chicago School of Economics is one of the predominant ones in the entire world, hardly a frequent source of irrational exuberance.


Beats the market average, as those schools go.


Fama is referenced about 8 times in Burton Malkiel's book, all in connection with a fellow researcher named Kenneth French.

So we're not talking about slouch concepts here.

But it's still quite a bit short-sighted, I think.


And thus something to avoid?


Maybe. Let's look deeper for a second.

Let's say all of that premise is true.


The all at the same time thing?


Yes, that's it.

It still misses a critical point.


Which is?


Which is that our brains don't work that way.


Example


It's a simple theory that you and I might have the same information at the same time. And we might then be able to act upon it in an identical way.

This would mean that neither one of us had an advantage and both of us had rational expectations.

We might as well throw darts at the stock page to get the same amounts of money.


Which is another old fable.


Unlike what we know about brains, such as, that we prioritize things.

Things more important to us get more of our attention.


Makes sense.



If DOING WELL what we both KNOW to be the right thing for us was also equal, then the book is true.

Problem is, that's not how an appetite for risk can show itself. That's not how reality works all the time.


How does reality work?


To help with explaining,

In investing, as with just about everything, you have to consider the relevant evidence and make a decision.


A decision about what? Return on investment?

It's way easier to do this when you have all of the facts the way fund managers do.

It's better when you have all of the facts at the same time as everybody else.

That is efficient market theory, and what a fair market is all about.


So it's decisions about the stock market.


Yep. Or really any other investing market which an actual investor might encounter.

I'm here to tell you that you can apply this to things other than investing.


Why?


Because, like with other things, it relies on your attitude.


The connection might be clear to you.


But, it's not clear to YOU?


Correct-a-mundo! (mumbles) That's not actual Spanish.


If you think you'll be hampered by not having THE SOMETHING, the fastest information or whatever, then you WILL in fact BE HAMPERED.

We'll get into the quality of the theory itself of course.

I ask you first to be honest with yourself about why this message was necessary.


Are you saying that the theory is wrong?


Not at all. I'll let others do that.


What is it then?


I'm looking behind the scenes here. Focus on the actual question I asked.


You didn't ask a question.


That's true Mr. Grammarian. Okay, here goes: Why was this message necessary?


And?


Remember the mention of MSIs?


Of course! I'm actually going to start one!


Oh really? We'll have to talk about that more, but for now, it's like I said before, the book might be another MSI, another stream of income, another gem for the alert investor.


Isn't that a pretty mercenary sort of look?


Okay, then we just imagine a supporting purpose, where some people hear a podcast and others connect better with books.


That's a different look at the same facts.


Exactly, DT. And that's what we have to do with investing.

Now, this theory, this Efficient Markets Hypothesis, especially the Random Walk Model, has frequently been debunked.


By anyone we know? Anyone we'd put "smart money" on?


Probably. Warren Buffett, you may have heard of him, has said that Efficient market theory is "silly"

Since the Internet has been introduced into the mix, the likelihood that people have all of the same information at the same time has increased.

But it doesn't really happen.


It's more like "inefficient markets", right?


Sort of. If everybody had the same information at the same time, if everybody had the same model of risk, then everybody would perform exactly the same way. And clearly, that does not happen either.

Malkiel does attempt to connect this theory to the then-emerging field of behavioral finance, of which I am a big fan.

But even when he correctly identifies psychological phenomena like "hindsight bias", he immediately goes on to try to bridge that connection to the idea that since a private financial analyst will just charge you too much, you have to do it his way.


But that would save a lot of trading fees over a span of time, wouldn't it?


There's certainly a body of evidence that it could give you a big advantage over time, but in reality, it causes so much confusion that people don't invest.

Instead, they call that being better off.

Really, it's their own personal financial crisis.


But you preach not needing a broker.


True DT, but that's because I was one, and I know the motivations as well as the how to do it part.


Which is what you share.


Thanks, DT. And before you ask, I promise to share the investing connection right after this short break.


So how does this connect?


I'm going to have to work on you starting sentences with "so".



Lots of people do that! It's basic logic!


Doesn't make it right.


Oh say something funny, why don't you?


Okay, If you think you missed the train, then you missed the train.


What?


We missed this one. We did the dot-com thing. We sucked the asset bubbles. We… It was sad and complicated, even stressful.

Where, in all the cacophony, is the simple answer?


Save 10%


Wait, what?


Save 10%. Use your attitude and save 10%!


Are you trying to be me?

I mean, next, you'll say things like "Max your 401(k)" or "Pay off your credit cards" or something.


Nope, surprise! "Buy index mutual funds".


Oh, that's awesome. That's what the book was also saying!


Okay, now I'm confused. Isn't that good?


Could be. Just be clear on results versus reasons.


Explain.


It's a good result because you'd be investing.


But...


But it's not a good reason.


Why isn't it a good reason?


It confuses telling you that everyone has the same information while also telling you that you can't ever know what the so-called professionals know, like what's an undervalued stock.


Implying abnormal returns.


But not excess returns.


Please finish on why that would be bad.


Because it has its own result. Ordinary investors, or what I prefer to call "people", just avoid the problem by not investing at all.


Oh! So this ties into investing in that it's important to do it!


Yes! You got it DT! And do it over and over again, so you can...


Remember, ALL YOU NEED TO DO IS PRACTICE, AFTER WHICH YOU’LL GET GOOD!


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