The future? Your guess is as good as mine

1st November, 2008

The stock market is efficient.

It might seem a strange time to be making that claim, but despite its apparent absurdity I am now convinced that it is by far the most sensible way for an investor to look at the world. It may even be broadly true.

The efficient market hypothesis states that historical information provides no help in forecasting share prices. That would mean that examining graphs of a share’s performance, even reading this morning’s FT, would not produce a reliable strategy for judging the price of a share tomorrow or next year. That is because all useful information would already have been assimilated in today’s price. Paul Samuelson, perhaps the most influential economist of the 20th century, summed it up in 1965 in the title of his article: “Proof that Properly Anticipated Prices Fluctuate Randomly.” Since all available information is already reflected in the price, future prices will move only as news arrives. News itself arrives unpredictably, otherwise it is not news.

If the efficient markets hypothesis is true, then sensible economists will admit that they simply do not know what the outlook is for the stock market. How dull! It is much more fun to have somebody predict the future.

Yet it would explain the recent edition of FT Money in which the two star columnists offered precisely opposing views on the outlook for the stock market: Anthony Bolton anticipating recovery and Merryn Somerset Webb arguing that the market is still too optimistic about the future. Are they then both charlatans? Not at all. In an efficient market, disagreements between well-informed people are exactly what one would expect. Both are equally likely to be right.

The hypothesis is affectionately lampooned by a famous old joke about two economists who pass a $100 bill on the street. One reaches to pick it up, and his friend tells him not to be absurd. There couldn’t possibly be a $100 bill lying in the street because someone would already have picked it up.

The joke is a good one, but nobody has convincingly proved or disproved that the efficient markets hypothesis is true.

Nevertheless, investors should act as if it is. Belief in efficient financial markets suggests a three-pronged investment strategy. First, ignore advertisements (and newspaper articles) that tout the past performance of particular sectors or funds. In an efficient market, past performance is not only no guarantee of future performance, it offers no clue whatsoever. Second, don’t try to pick stocks and don’t ask others to pick stocks for you: in other words, choose a low-cost index tracker. Third, don’t try to time the market: get in and out gradually.

This third point is not widely appreciated enough. While many investors now realise the attractions of tracker funds, few realise that the typical fund does much better than the typical investor. This is because investors tend to buy high and sell low. Ilia Dichev of the University of Michigan has recently calculated “dollar-weighted” returns for major stock indices – a good adjustment for the tendency of investors to plunge into the markets as they are about to turn bearish. Dichev found that such returns were lower than “buy and hold” returns by 1.3 percentage points annually – 8.6 per cent instead of 9.9 per cent – between 1926 and 2002 on the New York Stock Exchange and American Stock Exchange. For a long-term investor this is a big difference. The same picture holds true since the early 1970s for international markets, and dramatically so for Nasdaq.

Perhaps the market is not efficient after all. All I know is that those of us who act as though it is have a substantial advantage over the typical investor.

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