July, 2020.
By Jeff Headrick, Financial Planner
The efficient market hypothesis is a hypothesis that states that stock markets share prices genuinely reflect the reality of their worth. The assumption with efficient market hypothesis is that the market’s efficiency in valuing stock is laser quick and accurate. By its very nature, hypothetically, the efficient market hypothesis does not permit investors to find value.
In other words, don’t try to outsmart the market. It simply is what it is, and the only way to increase your return is to take on additional risk.
At Inspire Financial Planning, there is a portion of our brains that agree with the efficient market hypothesis. There is certainly a lot of research that indicates that a buy-and-hold approach in a passive portfolio can serve you extremely well over time. Based on my professional investment experience over the last 20 years I can attest that this mindset can serve you well over time if you stick with it.
The Other Side of the Coin
Opponents of the efficient market hypothesis believe that it is possible to beat the market and that stock prices can often be found and purchased below their present value. This method of investing is called active portfolio management. With active portfolio management you are using fundamental and technical research and hopefully decades of experience in order to beat the passive portfolios that the efficient market hypothesis aficionados so dearly love.
“Even if you got lucky placing some trades during the Covid crisis back in March, humble yourself enough to know that to keep from getting your portfolio downsized in the future you have to consistently do this sort of spectacular decision-making steadily over time. You can’t screw it up.”
With Everything There is Irony
When most people think of passive investing, a company called Vanguard typically comes to mind. One of the greatest investment minds of this century was their founder the late Jack Bogle who was a big fan of the efficient market hypothesis. He used this theory to build Vanguard into a $6 trillion mega investment organization*, largely using either mutual funds or exchange traded funds that have extremely low fees.
What’s interesting is that while Vanguard leads the industry with their passive methodology and low-cost funds, they began offering active investments about 20 years ago. The irony of the argument is that both strategies can be effective. Even the biggest names in the business can’t decide which is best.
2020 The Year of the Covid-19 Virus
This year in particular has been an interesting year in which to study the efficient market hypothesis. For example, if you were to pull all of your stocks out of the market in search of safety back in March, you would have missed one of the biggest upticks in stock market history. An active market play like that will get your portfolio trimmed most of the time. That’s why we always advise not to panic when the market starts these gyrations. Any well studied investor should simply know better.
What’s interesting is that that many let their emotions get the best of them-- and then utilize ridiculously simple technology to perform trades that will inevitably lose them money, as well as a lot of time that will be needed to grow this portfolio back to where it once was.
Final Thoughts on the Efficient Market Hypothesis
The efficient market hypothesis is just that— it’s a hypothesis. No one strategy wins every time. While professional money managers have to work hard to perform, there are always managers that are able to stay ahead of the curve—ahead of the hypothesis. This alpha is usually one or two percentage points over the long-term average of a passive competitor—and even that one or two percent is extremely hard to come by— but it is not an insurmountable goal. It also adds up to substantial ROI over 20 and 30 year time frames.
How to Become a Great Investor
To become a great investor, you have to maintain an open mind. Just as importantly and maybe even more so, you have to maintain an elevated level of humility. Even if you got lucky placing some trades during the Covid crisis back in March, humble yourself enough to know that to keep from getting your portfolio downsized in the future you have to consistently do this sort of spectacular decision-making steadily over time. You can’t screw it up.
While the market can be very generous providing quick gains for the aggressive investor, it can be brutally cruel when it comes to crushing these gains in more turbulent times that surely lie ahead.
If you are young you have time to experiment. You have time to make mistakes and learn from them. If you’re over the age of 50 I would recommend that you remain more passive than active-- unless you are using a seasoned financial advisor to guide you between the two.
Resources:
https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp
* https://about.vanguard.com/who-we-are/fast-facts/
https://www.capitalgroup.com/individual/investments/fund/gfffx
Related:
https://www.inspirefp.net/blog/coronavirus-havoc-strategies-for-an-election-year
https://www.inspirefp.net/blog/buy-low-sell-high
About the Author
Jeff Headrick is an independent financial planner and wealth manager with Inspire Financial Planning. When Jeff was still in his teens his father died unexpectedly. While his father was a hard worker and a good provider, he did not have the best financial plan in place when he died. This left his family at a difficult financial crossroad. This personal experience, coupled with being inspired by Sir John Templeton, Warren Buffett, Dave Ramsey, and the laws of compound interest, prompted Jeff to enter the financial services industry in 1999. He has been helping people with their financial planning ever since. Jeff lives in Wilmington, NC with his wife and two children. He spends most of his spare time just across the Intracoastal Waterway in Wrightsville Beach, enjoying the beauty of the NC Coast.
Charts and graphs contained herein should not serve as the sole determining factor for making investment decisions. All hypothetical scenarios are for illustrative purposes only. Investment Advisory Services offered through AlphaStar Capital Management, LLC a SEC Registered Investment Adviser. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the adviser has attained a particular level of skill or ability. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Diversification does not guarantee profit nor is it guaranteed to protect assets. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Past performance does not guarantee future results.
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