by Rob Bennett

The most important question in the study of investing is — Is market efficiency real?

A belief in market efficiency is a belief that the stock market takes into consideration all known factors that bear on price when setting stock prices. If market efficiency is real, Buy-and-Hold is the ideal strategy. Stocks offer higher returns than other asset classes and there is no way to know in advance when returns will be good and when returns will be bad. So the smart strategy is to invest heavily in stocks and to maintain the same stock allocation at all times.

If market efficiency is not real, Buy-and-Hold is the most dangerous strategy imaginable. A market that fails to take all factors into consideration for a time thereby sets the stage for a stock crash and an economic crisis. Responsible investors want to protect both their portfolios and the societies in which they live from the terrible effects of mispriced markets and can do so only by pushing prices back to fair value before prices get too out of hand. To do so, they must change their stock allocations. At times when Buy-and-Hold becomes popular, our only means of protection from the crushing effects of runaway bull markets is forsaken.

The entire historical record argues against market efficiency. The case is so strong that it is difficult to imagine what it is that the millions who believe in market efficiency (this group includes many people with a strong knowledge of the literature discrediting the efficiency concept) are thinking.

The best explanation of this confounding reality that I have read is the one put forward in a research paper published in 2006 by Jeeman Jung and Robert Shiller. The paper is titled “Samuelson’s Dictum and the Stock Market.” Jung and Shiller state: “The faith that has in the past been expressed for the simple efficient markets model for the aggregate stock market is the result of a faulty extrapolation to the aggregate of a model that did indeed have some value for individual firms.”

That sounds right to me. Index funds were not available in the days when the Efficient Market Theory was being developed. The researchers responsible for the theory were not testing for macro efficiency (proper pricing of the market as a whole) because no one was interested at the time in knowing when the market as a whole offered a good buy. They were interested in learning whether individual stocks were priced properly relative to one another (micro efficiency). The paper notes that, while there is zero evidence for macro efficiency (the aspect of the theory that led to the insane bull market and the economic crisis that followed from it), there is indeed a good bit of evidence supporting claims of micro efficiency.

Economist Paul Samuelson is cited in the paper as the person who first made this critical distinction. Samulson wrote: “Modern markets show considerable micro efficiency (for the reason that the minority who spot aberrations from micro efficiency can make money from those occurrences and, in doing so, they tend to wipe out any persistent inefficiencies). In no contradiction to the previous sentence, I had hypothesized considerable macro inefficiency, in the sense of long waves in the time series of aggregate indexes of security prices below and above various definitions of fundamental values.”

There’s money to be made exploiting micro inefficiencies (through arbitrage transactions, for example)! But there is no effective means of making money exploiting macro inefficiencies. So it is silly to deny the 140 years of historical data showing that the market is often wildly mispriced and that Buy-and-Hold strategies pose a mortal threat both to the investors who adopt them and to the societies that tolerate widespread promotion of them.

My guess is that many academics understand this. But the academics who work in this field are today to a considerable extent in bed with the Wall Street firms that prefer not to make the distinction because Buy-and-Hold strategies have proven to be such a marketing bonanza. Tell people that there is research showing that stocks are always the best investment choice and you break down the aversion to losses that otherwise would cause middle-class investors to exercise more prudence in their investing decisions.

This is a case where word games have been employed to put science to use in furtherance of what can fairly be characterized as a Get Rich Quick investing scheme even though a responsible description of the findings of the underlying research would show that it possesses genuine value when not distorted for profit-seeking purposes.

My personal take, though, is that it is a mistake to conclude even that micro efficiency is firmly established as the sole factor influencing individual stock prices. Jung and Shiller show that there is evidence for micro efficiency. But given the level of emotion that we see operating in the decision-making processes even of experts in the field, it is hard for me to accept that there are not inefficiencies available today for smart stock pickers to exploit.

The historical data offers zero support for claims of macro efficiency. It offers some grounds for belief in micro efficiency. Claims that it is a futile effort to pick stocks overreach. It is fair to say that it takes skill and work to pick stocks effectively and that the typical middle-class investor is probably better off investing in indexes. I do not see support in the data for the claims often heard that stock picking doesn’t work even for sophisticated investors. Those claims too are the work product of marketers, not researchers.

Rob Bennett believes that Irrational Exuberance is the most important book on investing ever published. His bio is here.