The Efficient Market Hypothesis (EMH) is the underpinning of my investment philosophy. This philosophy informs the investment strategy I use personally as well as for clients.
But just what is it? Today I define EMH and explain it with the story of Sylvia, Fred and Nora. (Based on a story told by Weston Wellington, a Dimensional Fund Advisor executive.)
The Efficient Market Hypothesis states that the current prices of publicly traded securities incorporate all available information and expectations.
Publicly traded securities are those you buy on the stock exchange.
Traditional stock pickers attempt to make money by identifying “mispriced” securities and buying those deemed “underpriced”.
Adherents of the EMH embrace market pricing and reject the idea that securities are “mispriced”.
To illustrate I tell the story of Sylvia, Fred, Nora, and you.
Let’s suppose that you dear reader are an art dealer.
Let’s further suppose your lovely elderly neighbor Sylvia passes away after a long illness.
Her son Fred cleans out her house, decides what items he wants to keep and holds a yard sale to sell the rest.
Remarkably, on the day of the sale, you see that Fred has just put a Rembrandt painting in the front yard with a $50 tag on it! He has no idea that it’s a Rembrandt.
You casually walk over, planning to buy it and make a killing. But just as you’re about to close the deal your other neighbor, Nora the nosy art historian, swoops in to offer more.
Now there are 2 knowledgeable bidders on the scene.
How soon do you think the price will reflect the bidders’ information?
How soon will the price come close to the actual value?
The stock market is an information processing machine. Every day in the global stock marketplace there are 82.7 million trades! Every single buyer and seller comes to the table with INFORMATION.
There are millions of nosy Noras.
All of this information is incorporated into the price and prices incorporate new information very quickly.
You do not have any information that no one else knows. If you do, then you are an insider, and insider-trading is illegal!
In the stock market, the market’s pricing power works against investors who try to outperform through stock picking.
So if it’s underpriced items you’re looking for to sell at a profit – stick to yard sales. And hope that you get up earlier than Nosy Nora.
To learn more watch this 2 minute video from Dimensional “The Power of Markets” click here.
