The EMH stands for the Efficient Market Hypothesis (aka Efficient Market Theory) and it's an investment theory about how share prices reflect all the information available on those shares.
Shares are always traded at their fair value and it is therefore impossible to buy undervalued or sell overpriced stocks.
In English, it suggests that the market can't be beaten.
There is strong support for this theory (e.g. index funds tend to do a lot better than mutual funds in efficient markets) but the dissension is equally strong. If the EMH always held true, beating the market would be impossible. By extension, investors would also be self-imposing limitations on their returns.
Ditching the EMH
Some fund managers (e.g. Bruce Kovner) have statistically improbable records of beating the market to the point that if the EMH were true, this would have been impossible. The history of their portfolios alone pretty much disproves the EMH. But here are three points as to why I do not subscribe to the EMH.
1. Chess game
In chess, you have rules and boundaries. Pawns can only forward and bishops, diagonally. The same goes for investing, there are basic guidelines that people generally follow.
Yet the idea that everyone can use the same information that the market provides with the same skill – the Chess Analogy – is faulty. Despite the limitations of the rules, forward thinking strategies can change the outcome of the market return vastly.
Furthermore, some people in the market are not even trying to 'win', they are just hedging, or are affected by government intervention.
Because we are not all playing for the same rules or method of winning, it constantly creates inefficiencies in the market that can be exploited for higher returns.
2. Market Lag
I emphasize this point because it is important for an investor like me with experience with efficient markets like the US and Singapore. It is true that prices reflect stock information but the problem is that it takes time for the information to be reflected in the prices. Furthermore, this time lag can be so substantial that it was, to a certain degree, a contributing factor to the 2008 financial crisis.
Even as early as 2006, the default rate for subprime mortgages was increasing, and this was very obvious to people who looked. Bankruptcies and mortgage bankruptcies were going through the roof but these changes were not reflected in the mortgage prices at all. If anything, the prices went up. People still believed that they were secure.
The prices reflected people’s belief that their investments were secure rather than the reality of what was happening. It was about emotion and emotion is subjective and emotion is unreliable. When the reality kicked in later, prices started plummeting and firms started failing.
That's market lag.
Meanwhile, experienced investors who had looked took advantage of this market lag and that’s why you have films like 'The Big Short'*. People saw the changes no one else did, and took advantage of the situation no one else saw coming.
*I highly recommend this film. It's a great way to understand shorting the market.
3. Value Investing
If the EMH were true, there would be no value investing. This is a strategy in which you invest in undervalued stocks with the aim of profiting when their value increases (correction).
Self-imposed Limitations on your Returns
Subscribing to the EMH is akin to building a ceiling over your returns. If you believe that beating the market is impossible then your investment strategy will be structured at tracking the market with passive investment tools such as index funds.
However, if you're young with a long investment time horizon, I always recommend pushing yourself a little further with more aggressive returns, especially with emerging markets (EM).
Emerging Market Funds/Inefficient Markets
Let's discuss a typical strategy that I pull off regularly.
I usually stray away from Exchange-Traded Funds (ETFs) not because I can't sell them, but because they lose out to specific funds.
Given your 10, 20, 30-year investment time horizon, taking lower risks means you are going to lose out on much higher returns and compounding interest in the long run.
The reason why funds, mutual funds in particular, are unattractive is because of their costs. However, you all know that if you want something of quality, you have to be willing to pay for it.
Once you accept the higher costs as a 'necessary evil', you can easily find an active fund that beats the EM market index, and EM market indices generally beat efficient markets in terms of annualized performance.
If we compare an efficient market to an A student, an emerging market would be an F student. An A student will always score an A or an A+, so the improvement in their grades (your investment returns) will always be small. However, the only direction an F student can go is up. The jump in scores from an F to a D, B or even an A would be momentous (and so would your returns).
It’s okay to invest in an efficient markets because they have consistency but at the end of the day, if you invest in emerging markets, it’ll only be additional money for you.
Compounding interest can be a magical thing when it comes to growing your wealth but it needs time to roll. So, when are you going to start?
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Co-written by Samantha Tay.