… and, loving it!

Monday’s post set out to use a reasonably obscure study on the success of Warren Buffett [hint: it’s NOT due to luck] to ‘prove’ that the efficient market theorists are wrong …

… but, first, what is Efficient Market Theory, anyway?

Well, our trust Wikipedia entry says:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or newsin the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

The principle is that there are thousands of stocks to choose from and each company is divided into millions of pieces (i.e. each piece of stock) with millions of individual buyers and sellers (from large institutions to small, individual buyers and sellers) all operating in a regulated, open market that ensures that all information that may affect the current or future share price is published.

Therefore, everybody should be factoring all of the same information to come up with a fair value for each stock, all of the time …

… or, so the theory goes.

But, there are some obvious ‘cracks’ in this theory:

Enron

When a company like Enron misreports its numbers and misrepresents its business prospects and business model, the price of the stock can be widely different to its real (or, intrinsic) value. We know the result of this one 🙂

Martha

When a person has access to special information about a company – that may affect its current or future price – through ‘inside’ contacts … and, that knowledge has not yet been published … then they can purchase (or sell) a stock a a price that may change dramatically once that information does reach the market. Of course, this is not legal; it’s called ‘Insider Trading … and, we know the result of this one, too 😉

Warren

The study that I mentioned yesterday clearly shows that Warren Buffett’s success is NOT the result of luck, or taking additional risks, but clearly and unequivocally due to his “superior stock picking skills” …

… but, how is this possible if Warren is acting legally, ethically, and with the SAME information available to everybody else?

It’s simple: efficient market theory is wrong … SOME of the time. In fact, often enough to allow investors like you and I – and, especially Warren Buffett – to make a killing … IF we are patient in both buying and selling:

Warren Buffett’s mentor, Benjamin Graham, discovered that some stocks were priced less than their current book value and he bought those stocks, typically looking to make a quick (< 2 year) killing and move on … he was successful enough at this that Warren, as his star pupil, took notice.

Warren soon found that he could simply buy and hold such stocks – and, look for ANY stock trading below it’s ‘intrinsic value’ (the discounted value of its future cashflows, as compared to treasury bonds + a suitable ‘risk’ margin).

Needless to say, student eventually outperformed teacher … but, BOTH outperformed the Efficient Market Theorists.

Here’s how YOU can do the same:

Pick up a book such as Rule #1 Investingby Phil Town (which, despite the title, is NOT Warren Buffett’s OR Benjamin Graham’s methods) or any other credible book on Value Investing (which simply means to buy a stock at less than its ‘true’ value).

Use that book to help you find stocks that some Efficient Market Fool is willing to sell to you for current market price, which HE believes is also fair market price (after all, if its that price, efficient market theory says it MUST be fair), but YOU know is a helluva bargain, and …

… wait until time and circumstance reprices that stock dramatically upwards, so that its market price and your estimate of its true/intrinsic value pretty much match.

What should you do then? Simple.

Sell it back to the same (or some other) Efficient Market Fool!

You see, you rely on these few facts:

1. Efficient Market Theory IS correct MOST of the time,

2. But, it is wrong SOME of the time,

3. And, when it is wrong – as long as the business of the underlying stock is sound – the Market will (eventually) correct its mistake!

The trick is simply to have the time and energy – and, the simple tools – to find such stocks, and the patience and discipline to wait for the correction …

… it makes Warren 21% a year; it should make you at least 15%

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4 thoughts on “… and, loving it!

  1. Pingback: You might want to screen the advice from your ‘experts’ a little better … « How to Make 7 Million in 7 Years™

  2. In my humble opinion, the author is wrong regarding the “obvious cracks” of the theory.

    1) Enron , Intrinsic Value

    “EMH does not require a stock’s price to reflect a company’s future performance, just the best possible estimate or forecast of future performance that can be made with publicly available information. That estimate may still be grossly wrong without violating EMH.”

    Quoted from :
    http://en.wikipedia.org/wiki/Efficient_market_hypothesis#Popular_reception

    2) Martha, Inside Information

    EMH categorize how efficient a market is using 3 forms.

    Weak : No excess returns through historical prices.
    Semi-Strong : No excess returns through public fundamental info.
    Strong : No excess returns through inside info.

    For example, a fundamental analyst would be able to earn excess profits in a Weak form efficient market without violating EMH.

    “If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored.”

    Quoted from :
    http://en.wikipedia.org/wiki/Efficient_market_hypothesis#Theoretical_background

    3) Warren Buffett

    First of all, do we understand the exact methods and reasoning used to prove that Warren Buffett did not outperform the market due to luck?

    Next, why should anyone believe that Warren Buffett has access to the same information that we do? For example, he might be able to meet with top management of multi-million dollar firms to discuss the prospects of the firm while we are unable to.

    4) David Swensen

    David Swensen, PhD Economics from Yale, uses Modern Portfolio Theory to deliver 17.8% annual returns over 10 years while managing Yale’s multi-billion dollar funds. (wiki for David F. Swensen, he even wrote a book about his methods)

    —————-

    No offense to the author but I believe the author made those comments about EMH due to an inadequate understanding of EMH rather than those being actual flaws in the theory.

  3. @ Tommy – You can’t have it both ways: Warren Buffett having access to ‘insider information’ and Martha Stewart’s ‘insider trading’ are much the same.

    But, again you are disputing one study (Warren Buffett = skill not luck) to prove another study (EMH = the bees knees); I could argue the exact reverse!

    David’s Swenson’s results are only over 10 years … THAT could be the result of luck, since the period is relatively short.

    On the other hand, Warren Buffett has produced a 21+% compounded return for over 40 years, and you can’t tell me that when he first started producing those returns that he had the ear of the Chairman of Coke?! 🙂

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