In The Only Guide To A Winning Investment Strategy You’ll Ever Need, Larry Swedroe dedicated a major portion of the book to the discussion of the Efficient Market Hypothesis (EMH), specifically to explain why investing in passively managed funds is a winning investment strategy.
What is Efficient Market Hypothesis?
The Efficient Market Hypothesis asserts that the current market prices on traded assets, e.g., stocks, bonds, or properties, already reflect the total knowledge and expectation of all investors. It is unlikely that any one investor could use the information available to consistently produce above-market returns.
Larry also introduces two other efficiencies in his book — i.e., cost and risk:
- Cost Efficient — The market is “cost efficient if the investor’s cost to enter into a market transaction is relative low… The more cost inefficient the market (the greater the spread between the bid and offer), however, the greater are both the cost of trading and the barriers active managers must overcome in order to beat their benchmarks.”
- Risk Efficient — The market is risk efficient if “investments that entail greater risk provide investors with greater expected returns as compensation for the greater risk assumed.” For instance, stock has higher expected return than government treasury due to risks associated with investing in the stock market.
Why Does the Efficient Market Hypothesis Matters?
Efficient market hypothesis is important to understand because it explains why passively managed funds outperforms actively managed funds.
1. The costs of research and management
The main premise of active management is that superior performance can be achieved through research; specifically, by identifying mispriced investments and taking advantage of them. However, the cost of research and management is the first barrier that actively manage funds must overcome to beat their passively managed counterparts.
In other word, one reason why passively managed funds are superior to actively managed funds is their low costs (i.e., expense ratios, management fees, etc.) I demonstrated this concept, where a difference of 0.5% in expense ratio could result in a portfolio that under perform by nearly 15% over the course of 30 years.
2. The costs of trading
The second barrier that actively managed funds must overcome to beat passively managed funds is the costs of trading. The costs of trading include selling costs, buying costs, and the bid-offer spread.
It’s interesting thing to note when information efficiency is lower — i.e., lightly traded stocks, emerging markets, etc. — the cost inefficiency takes over and wipe out any advantage of active management. For instance, information dissemination is slower for smaller stocks, but that advantage is wiped out by the higher bid-offer spread.
Lastly, investors who hold actively managed funds in their taxable account have to contend with taxes. Specifically, there are two that these investors have to deal with:
- Depending on the level of turnover, or how much trading was done, the fund could accrue significant amount of capital gains. These capital gains result in capital gains distribution at the end of the year which is subject tax.
- Likewise, dividends result in distribution which is subject to tax.
In short, actively managed funds are unlikely to outperform passively managed funds due to the costs associated with actively managed funds. Moreover, it’s unlikely that active managers can consistently identify and take advantage of mispriced stocks to outperform the indices due to the Efficient Market Hypothesis.
For more information about Efficient Market Hypothesis, and passive investing as a winning investment strategy, I recommend The Only Guide to a Winning Investment Strategy You’ll Ever Need by Larry Swedroe
What others are saying about Efficient Market Hypothesis:
- Creative uses of efficient markets at Freakonomics
- Weekly Market Commentary, March 4th 2008 at Stock Trading To Go
- Is the Market Efficient? (Part 1 of 3) at Million Dollar Journey
- The efficient market hypothesis at Early Retirement Extreme
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
great summary of EMH. This was such a mind-blowing concept when I first learned it in school. It’s controversial because it essentially calls out an entire industry of forecasters and stock-pickers…the so-called “experts” and says that their job is meaningless….not something that is popular on Wall Street. “Random Walk Down Wall Street,” explains the same concept and is still the scorn of many streeters.
I completely agree. I do own actively managed mutual funds, in addition to index-based funds and ETFs, but I am a buy-and-hold-type investor and I always look for low-cost, tax-efficient funds. Even within actively managed funds, there are huge differences in cost. I like many of the T. Rowe Price offerings for this reason.
Thanks for the reference Pinyo.
Great overview of EMH. It is an important idea that can save investors from the sharks on Wall Street. Bring on the index funds!
MDJ’s series on the topic was quite excellent.
Interestingly enough another blogger I read posted on the exact same topic today….
Needless to say I’m a pretty big believer in the emh.
Look at a 10 year chart of the following funds – then tell me indexing is better! vfinx,vtsmx (look pretty much the same don’t they?) vbinx – for your index funds. dodbx,gatex, prpfx, lcorx – all active funds. Which ones have more consistent returns? Which ones did a better job of preserving capital in the last bear market? Is it better to save 0.5% in management fees to lose 1/2 your money? That’s a rough ride – a ride which most people will bail out of and then miss the ride back up. If markets were really efficient then all… Read more »
Oh, and somebody answer me this…… Why do Vanguard’s actively managed funds beat their index funds? Hmmm? C’mon now – you didn’t know that? Shame on you.
When everybody is doing it, whatever IT is, then it’s best to get out of it. The smart money NEVER invests with the herd. They get greedy when everyone else panics and they sell when everyone else is getting greedy.
Ever see a cattle drive before? Where are all those cows going? Yeah, that’s right, to the slaughterhouse.
Oh, and hey Cameron, you better check out Jeremy Siegel again. He’s got a “newer” idea.
Finally, for now at least, don’t mistake me for a Wall St sympathizer. I think they’re all crooks. They’re the ones who began the buy-and-hold scam. “Buy our funds and hold them” so they can screw you. Everyone here needs to get a subscription to Hulbert and spend some serious time evaluating several, if not dozens, of the top letters he tracks to find a strategy that rings with your personality and then stick to it. Be prepared to spend time and money investigating. There are some gems there. I won’t tell you which ones, though, because I’ve spent years… Read more »
I like Larry’s material I think that he makes a lot of sense for those of us who are releatively new to the investment game. Of course he is out to make a name for himself and plenty of other money too, but of the various authors I’ve read on the sbject of investment Larry’s is definately up there.
“It is unlikely that any one investor could use the information available to consistently produce above-market returns.”
Two words: Warren Buffett.
The Efficient Market Hypothesis was ripped from General Equilibrium Theory in Economics and applied to financial markets by jealous academics who couldn’t make a profit it in the real world. So many assumptions in the original EMH are bounded by axioms that are never present in real situations. For example, people are not always rational. We do stupid things. Emotions and emotional contagion do not coexist with rationality. Irrational behavior can dominate markets. If people were completely rational they would be somewhat predictable, at least on the aggregate level, and then you could profit and you would have a paradox… Read more »
@GL — “I believe the best way to invest is to buy a share of Berkshire-Hathaway and let the world’s best investor manage your money.”
I like your style and I do own some BRK-B (not enough I have to say). I wonder what’d happen when he retires.
@James — Thank you for your comment. I love to hear other perspective, especially ones that are different from mine. I can tell you are very knowledgeable about this subject and I appreciate your thought on this.
I know I’m a little late to the party on this, but being a market technician and individual investor I know that EMH is a rather ridiculous concept. The interesting part is that I use the initial assertion of “price includes all know aspects of the stock/index” for technical analysis. However, the author fails to mention the primary element in utilizing EMH: People, the so called “rational actors”. This is where EMH falls apart. You could have perfect information, but if you cannot make rational decisions, if you allow emotion to creep into your decision making, if you follow the… Read more »