Friday, November 28, 2008

What do we mean by market efficiency?

I ran into Jim again yesterday. Actually it would be more true to say that he ambushed me. I turned a corner and there he was. After the way he treated me in our first discussion (reported here) I was not particularly looking forward to talking to him again.

Jim said: “I enjoyed our last discussion”. I nodded agreement as I wondered why I wasn’t shaking my head the other way. Meanwhile, Jim was saying: “I heard that you wrote up our last discussion on your blog”. I must have looked a bit concerned because Jim said: “That’s OK. I don’t mind helping you with your blog, as long as you are accurate in reporting what I say and don’t make me look stupid”. I told Jim that might not be easy, but I could tell from the way he was looking that he obviously didn’t think it would be a joking matter if I made him look stupid - even though I wasn’t using his correct name on my blog. So I added that I was not going to report his expletives. Jim said that was OK. He claimed that he didn’t swear in any case, but if I wanted to I could use some bleeps now and then just to add emphasis. He said: “I won’t mind if you use a bit of poetic licence now and then, as long as you don’t make me look stupid”.

After he had bought me a beer Jim said that wanted to ask me something else. He said: “You believe that free markets are perfect don’t you?” I responded that I wasn’t quite sure what he was getting at. I told him that in my view all markets are imperfect, but when governments try to regulate them they often make matters worse. Jim said: “No, that’s not what I mean. I’m talking about capital markets – share prices and bond prices. Do you think those markets are close to perfect?”

At that point I explained to Jim that what he was talking about was the efficient markets hypothesis that prices always reflect all relevant information. I said it seemed to me that investors have the strongest possible incentive to make informed decisions because their personal wealth is at stake – and equity prices reflect the information on which investors base their decisions.

Jim said: “I’m not sure I understand. Are you saying that individual investors all have the same expectations about future prospects of particular firms?” I acknowledged that individuals have a lot of different views about the future. I suggested that even though a lot of investors think they can beat the market, the market averages out these different expectations, so those who do better than the market tend to be balanced by those who do worse than the market.

Jim nodded for me to continue. I explained that people who invest in funds with low management fees, whose weightings of individual shares in their portfolio are similar to a share market index, often do better than those who pay high management fees to funds that undertake a lot of research.

Jim said: “I suppose if someone has just lost half their capital on the share market they will not feel so bad if the value of their portfolio has fallen in proportion to the index and they have been paying low management fees.” I agreed.

Then Jim asked: “What do you think of Warren Buffett’s view that it is possible to beat the market because people are often irrational – they let greed take over and then they panic when fear takes over”. I said that I like Buffett’s approach to investing, but I wasn’t too keen on his politics.

Jim ignored the latter remark and asked: “So what advice do you think the Oracle of Omaha would give to novice investors about where to put their money?” I said that I imagined that he would tell them to put their money into Berkshire Hathaway. Jim replied: “Well, you don’t know everything! Buffett says that novice investors should stick with low-cost index funds.”

I checked to see whether or not Jim had just made this up. Warren Buffett actually gave this advice in April this year (reported here).

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