1. Efficient Markets?

The majority of today’s finance literature, teachings, and thinking is based on two concepts: the modern portfolio theory and the efficient market hypothesis. 

Investors who want to outperform the market don’t need to understand any of these concepts. We’ll see why in the next chapters. Nonetheless, we will still briefly introduce these concepts because they are the basis of much of today’s conventional wisdom, which tells you that you cannot outperform the market and so on.

Let’s start by looking at the basic theories, then at why the conventional wisdom is wrong, and how we can use this realization to outperform the market.

Modern Portfolio Theory

In 1952, the economist Harry Markowitz published the modern portfolio theory (short MTP)1, for which he later was rewarded the Nobel Prize.

What the Modern Portfolio Theory essentially says, is that the risk, and performance of a single stock is less important than how it impacts the entire portfolio.

A simple example: let’s say you build your own portfolio. You want to invest an equal amount in four stocks (25% each). The first stock is less risky with an expected return of 3%, the second is a little riskier, with an expected return of 5%, the third stock is even riskier, with an expected return of 10%, and the fourth of 17%. According to the modern portfolio theory, you can calculate the expected return as follows:

(3% x 25%) + (5% x 25%) + (10% x 25%) + (17% x 25%) = 8.1%

So, in general, the MTP proposes that you can reduce your investment risk by holding a diversified portfolio of multiple stocks.

Back in the 1950s, it was a game-changing idea to not invest in single stocks but to create larger portfolios of stocks where the risks of individual stocks get cancelled out.

What does this mean for an investor today?

Thanks to index funds and ETFs, today the majority of individual investors invest according to the modern portfolio theory. Because an index fund or ETF essentially is a broad and diversified portfolio of stocks, you are thereby – according to the modern portfolio theory – reducing your risk to a minimum.

Efficient Market Hypothesis

The idea that investors should hold a highly diversified portfolio was further endorsed by the economist Eugene Fama.

In 1970, Eugene Fama introduced the efficient market hypothesis2, which not only emphasizes that an investor’s risk is minimized by passively holding a diversified portfolio, but also suggests that sticking with the market is the only efficient way to invest money. 

According to the efficient market hypothesis, investors who achieve a higher return than the market as a whole were either exposed to a higher risk or they were simply lucky.

The underlying assumption of the efficient market hypothesis is that all information is freely available to every investor. There is no one who has access to insider information. As a result, the stock prices always adequately reflect the information available to every investor.

According to Eugene Fama, there are three different types of markets an investor can participate in: the weak market, the semi-strong market, and the strong market.

In the weak market, the investor only has access to historical price and return data. The weak market is thus following a random walk which makes predicting the future market price impossible.

In the semi-strong market, the investor has access to all publicly available information such as news reports, earnings forecasts, and historical market prices. The stock market price therefore already reflects this information and is fair valued.

In the strong market, the investor has additionally access to all inside information – just as every other investor – and thus the stock price immediately reflects all available insider information.

The important assumption of the efficient market hypothesis is that all investors act rationally and hence use all available information. If some investors act irrational, their actions are random and these random market activities cancel each other out without having any impact on the market price.

The Efficient Market Hypothesis would have inevitable consequences for investors:

  1. The stock market is efficient and never mispriced, which means that investors cannot outperform the market except by luck.
  2. To reduce risk, investors need to invest their money in a widely diversified portfolio.
  3. The only and best investment strategy is to put one’s assets into a broad index fund or ETF and – to further reduce the risk – combine the index fund with risk-free assets like government bonds.

However, if the efficient market hypothesis were true, how can we explain the long-term investment results of investors like Warren Buffett, Walter Schloss, or Seth Klarman? 

By looking at the successes of many investors, we must assume that the efficient market hypothesis is false.

As Warren Buffett described the discord between scientific theories and real-world investing in 1997: “To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these.”

Not So Efficient Markets

Long before Eugene Fama introduced the efficient market hypothesis, it was observable that stocks sell at their – or close to their – all year’s low in December to then recover in January3. Some investors recognized this recurrence and achieved abnormally high returns by exploiting it. One possible explanation was that investors sell their poor performing stocks from their portfolio to realize a loss and thus lowering their capital gains tax. These higher returns were later confirmed by other researchers and then called the January effect.

There are many other examples of observations which contradict the efficient market hypothesis. Rolf W. Banz – for example – discovered a correlation between the stock return of a company and its market capitalization. Companies with a relatively small market capitalization showed a higher risk-adjusted return than medium- or large-sized companies with a remarkably higher market capitalization4. As a possible explanation, he suggested that information about smaller companies spread slower to investors than the news of large companies. As a result, small-cap investors can profit from a short-term value premium5.

The more obvious evidence why markets cannot be so efficient is the fact that active portfolio management exists. If the markets were truly efficient, and there would be no hope to beat the market, then nobody would pay to have their money actively managed.

The efficient market hypothesis says that as long one investor makes a profit, everyone makes a profit. And we all know that this is far from the truth.

By far the best example and evidence that markets are “not so efficient” is the Subreddit “r/wallstreetbets” – which is a forum like social media page geared towards one specific topic, in this case stock bets. In early 2021, users of the Subreddit were able to start a short squeeze on GameStop Corp ($GME). This happened after a research firm predicted the stock of GameStop to fall. A user apparently didn’t like this short seller and his short position against GameStop, so he generated interested in a counter-attack. The result? The GameStop stock price increased 600% within a single day and the trading of $GME was halted multiple times.

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Behavioral Biases

Investors do not act like rational calculation machines. Humans are prone to error; they are from time to time irrational. This is why behavioral finance emerged as a new research field to explain all the observations which are contrary to the modern portfolio theory and the efficient market hypothesis.

In 1974, the researchers Tversky and Kahneman6 were the first who showed that humans are bad at judging and predicting the likelihood and the frequency of an event.

Human biases – for example – prevent investors from correctly evaluating the growth potential of companies. As a result, investors tend to overpay for popular stocks. On the other hand, investors pay too little attention to unspectacular companies, which become undervalued as a result. These companies present a profitable investment opportunity as soon prices correct7.

Research extensively showed8910  that investors under- and overreact to different stock market situations. Humans put too much emphasis on a continuous row of good or bad news – leading to an under- or overreaction. Overall do these human biases lead to disadvantages for the investor when selecting his portfolio11.

The researchers Barber and Odean12 showed – for example – that men act in certain areas overconfident, including the stock market. They found that men were trading 45 percent more often than women. They also observed that overconfident investors overestimate the value of their information and thus also their expected returns on investments.

All in all, we can conclude that humans do not act rationally most of the time. Human psychology itself seems to be the most significant opponent of the efficient market hypothesis.

Institutional Biases

Not only biases of the human psychology have an impact on investment decisions. Glenn Greenwald describes13 two additional biases which are contradicting the efficient market hypothesis: biases of institutions and biases of people working for these institutions.

An undervaluation of a certain stock might occur due to two reasons:

  1. Policy Restrictions: Many large institutions have a minimum investment size, which means they cannot invest in companies which are too small, or they have to sell certain positions when stocks fall under a certain minimum market capitalization. Furthermore, money managers may be prohibited from investing in specific stocks, or they are limited to invest only in stocks which fulfill specific criteria – for example, social responsibility or merely being part of the S&P 500 index.
  2. Investment Size: Some institutions simply have too much money to manage and therefore are obliged to ignore companies with too small a market capitalization.

People working in investment companies also have biases. A fund manager will not risk his job and reputation by buying an unloved and undervalued stock. Instead, he will stick close to the index to fulfill or slightly outperform the expectations of his employer and – of course – to not scare off customers.

We can be sure that the market is full of biases which – at all time – can lead to an undervaluation or an overvaluation of certain stocks. An investor who is aware of this is one step ahead of the majority of investors. 

Or as Benjamin Graham states in his book The Intelligent Investor:  “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

Index Investing

We have already talked about the modern portfolio theory and the efficient market hypothesis. Both suggest that the best way for investors to reduce their exposure to risk and to efficiently arrive at the best possible return is to hold a broad portfolio of stocks which represents the market as a whole.

Now, it might be puzzling that Benjamin Graham – who is by many regarded as the father of value investing – recommended an index strategy to the majority of investors14

But there is an important difference. While the efficient market hypothesis states that no other strategy can possibly outperform the market on the long-term, Graham differentiated between two kinds of investors: the active and the passive investor. 

The active investor or – how Graham called him – the aggressive or enterprising investor is actively employing his time and knowledge to find, analyze and pick the right stocks. By investing intelligently, the active investor will outperform the market.

On the other side is the passive investor, which Graham also calls the defensive investor. The defensive investor lacks the time and the knowledge to pursue value investing. For that reason, the passive investor will step into all the pitfalls presented by human misjudgment and as a result underperform the market. The defensive investor is therefore best off by sticking to an index fund. 

That this is indeed correct showed an analysis of 70,000 investor portfolios on Openfolio15, which was a platform where users publicly shared their investment portfolios with other members of the community. The comparison showed that investors underperformed the S&P 500 index on average by seven percentage points in 2016.

Still, for an active value investor, it is possible to beat the market. The next chapters will describe in greater detail the underlying concepts and principles of value investing and subsequently dividend investing to look at what is possible.

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  1.  Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7(1), 77-91. 

  2. Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The Journal of Finance, 25(2), 383-417. 

  3. Wachtel, S. B. (1942). Certain observations on seasonal movements in stock prices. The journal of business of the University of Chicago, 15(2), 184-193. 

  4. Banz, R. W. (1981). The relationship between return and market value of common stocks. Journal of Financial Economics, 9(1), 3-18.  

  5. Hong, H., & Stein, J. C. (1999). A unified theory of underreaction, momentum trading, and overreaction in asset markets. The Journal of Finance, 54(6), 2143-2184.  

  6. Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(4157), 1124-1131. 

  7. Greenwald, B. C., Kahn, J., Sonkin, P. D., & Van Biema, M. (2004). Value investing: From Graham to Buffett and Beyond (pp. 21-22): John Wiley & Sons. 

  8. Barberis, N., Shleifer, A., & Vishny, R. (1998). A model of investor sentiment. Journal of Financial Economics, 49(3), 307-343. 

  9. Daniel, K., Hirshleifer, D., & Subrahmanyam, A. (1998). Investor psychology and security market under‐and overreactions. The Journal of Finance, 53(6), 1839-1885. 

  10. Hong, H., & Stein, J. C. (1999). A unified theory of underreaction, momentum trading, and overreaction in asset markets. The Journal of Finance, 54(6), 2143-2184. 

  11. Subrahmanyam, A. (2008). Behavioural finance: A review and synthesis. European Financial Management, 14(1), 12-29. 

  12. Barber, B. M., & Odean, T. (2001). Boys will be boys: Gender, overconfidence, and common stock investment. The Quarterly Journal of Economics, 116(1), 261-292. 

  13. Greenwald, B. C., Kahn, J., Sonkin, P. D., & Van Biema, M. (2004). Value investing: From Graham to Buffett and Beyond (pp. 21-23): John Wiley & Sons. 

  14. Graham, B. (1949). The Intelligent Investor. New York, USA: HarperBusiness Essentials. 

  15. Anderson, T. (2017). Most investors didn’t come close to beating the S&P 500. Retrieved October 28, 2017, from https://www.cnbc.com/2017/01/04/most-investors-didnt-come-close-to-beating-the-sp-500.html 


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