Saturday, March 26, 2011

We get rich when Efficient Market Hypothesis fails

Not only David Dreman is disagreeing with Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT). In 1960, Eugene Fama was one of the strongest advocates of EMH, but irony of ironies, in the 1990s, he and Kenneth French showed that the data did not support EMH. Who says that a scientific theory only becomes obsolete when its leading proponent dies?

Maybe it is the fact that investing is not a science that gave Fama the courage to review his opinion? Maybe in the world of investing, nothing is more costly than hanging on to improper tools? Or maybe in the investment world we care about the results rather than explaining those results with grand theories. After all, successful investors are pragmatic.

It is EMH that forms the basis of many investment strategies. It is in particular the EMH notion that market price reflects all facts and news about an investment that prevents us from reaching financial freedom. EMH states the price is unemotionally set by the market consensus of well informed investors. But if that was true, then nobody can outperform the market and the only thing that counts is the expenses you incur to acquire a basket of diversified investments. It is true that many mutual funds underperform the stock markets by the amount of their MERs (management expense ratio) and the buy and sell commissions. The only thing many of those mutual funds deliver is less volatility than the overall market. Only a select few of fund managers outperform the market – the most famous of those is Warren Buffett. Here in Canada we have Peter Cundill and John Templeton that are shining examples of investors that disproved the principals of EMH.

Between 2008 and 2010, Warren Buffett made some of his largest investments yet. Barely 2 years later, the wisdom and profitability of those investments cannot be denied. Lately we're talking more about black swans and Justin Fox's 'The Myth of the Rational Market'. But this is no real news, Ken Fisher and many other investors, ridiculed by the academic investor establishment, were for years telling and showing us that markets are much more complex. Markets are an amalgam of numerical logic and consensus emotionalism plus… That is why on this blog, we're talking about a diversified portfolio COMBINED with the breaks in your life.

Those breaks or investment opportunities come from many directions and it is your job as a successful investor to recognize these opportunities and grab them. But how can you take advantage of these opportunities if you don't have the skills to deal with them and optimize your profits? It takes a lifetime of learning and studying to be ready to take advantage of our breaks. Some luck out or are gifted with the talent to recognize 'breaks' at an early age. Warren Buffett claims that it is his luck to have those talents and to live in a country where he can take advantage of his talents. As Warren himself states, if he ever got shipwrecked on an uninhabited island Warren would undoubtedly perish because of his lack of survival skills while others would prosper (Tom Hanks and Robinson Crusoe come to mind).

Less than 4% of all real estate transaction involve investors with rental properties; most of us invest in paper securities. This is partly because investing in real estate requires a lot of work. Some of it can be delegated to rental pools and property managers, but then you still have to sit on condo and rental pool boards. Many real estate investors prefer this kind of control and the higher work load is reflected in part in the real estate returns; the higher level of control also allows the real estate investor to use leverage increasing profitability even more.

Most of us prefer paper securities and a hands-off approach. Only our money works (to some degree). Whether you are big in real estate or not, most successful investors own a diversified stock and bond portfolio. The returns of such a diversified portfolio are limited; we may become 'well off' but never wealthy. Also, in today's investment climate, fixed income instruments like bonds may help combat portfolio volatility, i.e. short term valuation risk, but over the longer term stocks clearly outperform. This may change when the government cycle of high deficits and high inflation peaks as it did in 1982 but that is probably still another 10 years away if not longer.

Therefore, we should aim for a diversified stock portfolio and be ready for a 'break' in the stock market or in our employment (company savings plan and/or stock options). For small investors creating a diversified portfolios is easiest achieved through buying a set of Exchange Traded Funds (ETFs) that reflect the Canadian stock market, the U.S. market, the European market and Emerging markets or better the BRIC countries. Alternatively, a larger investor could buy a portfolio of individual stocks. Don't own more than 30 to 40 companies. For more diversification, you could buy preferred shares, common shares and even some debentures for one and the same company.

The reason to buy not more than 30 to 40 companies is simple. Keeping track of them is going to be a full time job! In the meantime you have no other control over those companies than buying or selling their investment paper. We are typically not Karl Icahn who owns enough of a stock to force him onto the board gaining a measure of control that way.

For many of us, building a diversified portfolio is all we achieve. To become wealthy however, we need our 'breaks'. With sufficient experience, funds and knowledge we should position ourselves for the 'breaks' like buying individual companies during a market downturn and to make it into a lifetime opportunity that increases our net worth with leaps and bounds. Those are the investments where EMH is out of whack, a Black Swan opportunity you can take advantage of. So, it is kind of odd, but it is when EMH no longer works, when blood runs through the streets of the investment world, during the low tide when the naked investor is exposed that true wealth is created. We're making most of our money when the Efficient Market Hypothesis fails and is swept away by the emotions of market consensus. We all, even non-investors, know this already intuitively, but many of us don't have the stomach to take advantage of it. With increased knowledge and experience we should overcome our fears and grab the 'breaks'.

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