In his latest Wall Street Journal column, Jason Zweig offers an interesting take on the efficient market hypothesis, channeling the late, great Benjamin Graham for guidance.
Zweig says that while the stock market may give the most accurate estimate of a stock’s value based on the available information, that doesn’t mean its estimates are right. The reason, he says, involves the two main factors that Graham said go into a security’s price: ‘investment value’ (which measures the worth of all the cash a company will generate now and in the future), and the ‘speculative element’ (which is driven by sentiment and emotion).
“The market is quite efficient at processing the information that determines investment value,” Zweig writes. “But predicting the shifting emotions of tens of millions of people is no easy task. So the speculative element in pricing is prone to huge and rapid swings that can swamp investment value.”
Because of that, Zweig says that an inefficient market does not make for a market that’s easy to beat. In fact, he says that while it may be inefficient, the market “remains close to invincible,” and that most investors are best off sticking with index funds.
One reason: hindsight bias. Zweig notes that it may seem obvious today that Bank of America stock was dirt cheap back in March. “[But] last March, in the bowels of global financial panic, it was far from clear that Bank of America would survive and that the stock was dirt cheap,” Zweig says. “The market had priced such companies as if they might go out of business because plenty of information suggested that was a possibility, and because fear was then so pervasive that optimism felt almost like a form of irrationality. So, while it may seem obvious today that Bank of America is a survivor, most investors didn’t think the market price for the stock was too cheap last March.”
Zweig also says that fund managers chase returns, and those who are best at doing so attract more clients in up markets and lose fewer clients in down markets — which pushes prices further from the “investment value” of which Graham spoke. And, he says, fees make a huge dent in most investors’ bottom lines, another reason that index funds make sense.