Seeking Alpha is the scene of a debate around the viability of the Efficient Market Hypothesis (EMH). Before going very far into this topic, please keep in mind that we don't want this information to be scattered very far in the world of investing as we want active manager to keep throwing those $20 dollar bills on the ground so we as passive managers can come along a scoop them up for our portfolios.
While the topic of EMH sounds like something to be discussed only by the elite, it is fundamental to which path you are going to take as an investor. Will you go down the path of the active investor? This path is wide and many there be who find it. The passive path is straight and narrow and few there be that find it. There is a third path and that is the trail of the Mosaic Investor. The Mosaic Investor builds the core of their portfolio around index funds or index ETFs, but take a small percentage of the portfolio and dabbles in individual stock selection as a form of personal enjoyment.
EMH is all about the relationship between stock prices and the behavior of buyers and sellers. In short, the premise of the Efficient Market Hypothesis is: "Security prices fully reflect all available information." When one digs into the weeds of EMH, there are three levels to the hypothesis.
1. The strong form tests whether all know information, public and non-public (including insider trading), is reflected in security prices. One of the difficulties in running these tests is to know exactly what is included in all the information. How do we know whether or not our tests actually include all known information.
2. The second form is known as the semi-strong form and it is a slight variation of the strong form. Pulling information from Wikipedia, here is what they have to say about the semi-strong form. "It is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner."
3. Wikipedia also has a good description of the third form, the weak form where "…future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. This 'soft' EMH does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from market 'inefficiencies'. However, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock markets to trend over time periods of weeks or longer and that, moreover, there is a positive correlation between degree of trending and length of time period studied (but note that over long time periods, the trending is sinusoidal in appearance). Various explanations for such large and apparently non-random price movements have been promulgated."
Active investors support the weak form as it allows for possible alpha performance based on fundamental analysis. The question as to the viability of EMH comes back to portfolio performance. Quoting William Bernstein from his book, The Investor's Manifesto, he writes on page 51, "It slowly dawned on Fama that, in the long-run, almost no one had the ability to predict stock market moves or to successfully pick stocks. Random variation alone mandated that some market-timing strategies would succeed and that some money managers might outperform others. Eventually, however, the law of averages catches up with all of them."
Most investors who claim to outperform the market have not been selecting stocks for 40 or 50 years. And for those who have, there remains a few more challenging questions to answer.
1. What software is used to track portfolio performance and does it accurately handle cash moving in and out of the portfolio?
2. What benchmark is used to judge portfolio performance? Is the benchmark appropriate for the portfolio? Has the benchmark been customized for the portfolio?
3. What risk measuring tool is used to determine the volatility of the portfolio? Examples of risk measurement tools can be found within the TLH Spreadsheet in the form of the Sortino Ratio and the Retirement Ratio.
If one is able to provide reasonable answers to these three question and still performs better than their benchmark, then keep at it. We recognize there will be successful investors during different time frames. However, the overwhelming evidence still supports the Efficient Market Hypothesis.