A Purposeful Random Walk

If fundamentalists were pe lexed by why their results werent better, the academics certainly were not. Starting in the 1970s, they shifted their research firepower from the technical to the fundamental front. They made extensive studies of mutual funds, the great majority of which subscribe to security analysis. The professors demonstrated that the funds did no better than the market.

Academic analysis proved as unsparing of the fundamental practitioners sensibilities as of the technicians. Other prevailing beliefs were treated as harshly. No link was found between portfolio turnover and subsequent performance. Rapid turnover does not improve results, but seems to damage them slightly. No relationship was found between performance and sales charges.In sum, the reports firmly concluded that mutual funds do not outperform the market.

The results hardly comforted fund managers, who like to represent superior performance. The mutual fund manager not only unde er-formed the market, but adjusting for risk as the academics defined it, often fared even worse. Other researchers roughed up the poor manager just as harshly. At the time, the money managers appeared to be routed as badly as the Inca armies who fled from Pizarro and his terrifying cavalry. But, as well see, much ofthe seemingly awesome academic firepower was problematic or just plain wrong. In the 1960s, however, and for years afterward, it overwhelmed all opposition.

The Three Faces of EMH

To explain their discoveries, academic investigators, as we saw in the first chapter, proposed a revolutionary hypothesis. Today called "the semi-strong form" of the efficient market hypothesis, it holds that com-

positive for tliese stoclcs for several years and buyers jumped on the bandwagon in ever-increasing numbers. When technology stocks turned sour that fall, scores of major players all sold at once, often driving prices down as much as 50%. A sure way to buy high and sell low you say? Maybe, but popular all the same.

There is litde documentation from the schools or from the Street that momentum beats the market.* But why bother with facts? Evidence or no, it is one of the trendiest concepts in investing today. Once again, theory has little to do with reality.

* For more detail on the academic definition of risk see chapter 14 and Appendix A.

petition between sophisticated and knowledgeable investors keeps stock prices about where they should be. This happens because all facts that determine stock prices are analyzed by large numbers of interested investors. New information, such as a change in a companys earnings outlook or a dividend cut, is quickly digested and immediately reflected in the stock price. Like it or not, competition by so many investors, all seeking hidden values, makes stock prices reflect the best estimates of their real worth. Prices may not always be right, but they are unbiased, so if they are wrong, they are just as likely to be too high as too low.

Because the market is efficient, the theorists continue, investors should expect only a fair retum commensurate with the risk of purchasing a particular stock. Risk, as the theorists have defined it, is volatility. The greater the volatility of the security or portfolio, as measured against the market, the greater the risk. Securities or portfolios with greater risk should provide larger rewards.*

Since meaningful information enters the marketplace unpredictably, prices react in a random manner. This is the real reason that charting and technical analysis do not work. Nobody knows what new data will enter the market, whether it will be positive or negative, or whether it will affect the market as a whole, or only a single company.

The key premise of the semi-strong form of EMH is that the market reacts almost instantaneously and correctly to new information, so investors cannot benefit from it. To prove this thesis, researchers conducted a number of studies that they claimed validated it.

One important study explored the markets understanding of stock splits. In effect, when a stock is split, there is no free lunch-the shareholder still has the same proportionate ownership as before. If naive traders mn up the price, said the academics, knowledgeable investors will sell until its back in line, and market efficiency will be proved. And, said the researchers, this was indeed the case. Tests confirmed that stock prices after a split was distributed maintained about the same long-term relationship to market movements as before."

Another study measuring the eamings of 261 large 11 8 between 1946 and 1966 concluded that all but 10 to 15% of the data in the eamings reports was anticipated by the reporting month, indicating the markets awareness of information. Other tests came up with similar results, demonstrating, the professors said, that the market quickly adjusts to inputs.

Did these tests actually prove what they claim and cinch the case that

markets react quickly to new information? They did not, as we will see.

The semi-strong form of EMH is intuitively appeahng, because it explains the single most obvious mystery about investing: How can thousands of intelligent and hard-working professional stock-pickers be endlessly outwitted by the market and embarrassed by their selections? It also provides a rational explanation for the often inexphcable behavior of markets.

This form of EMH has much wider implications than the weak form, which said only that investors would not benefit from technical analysis. The new argument, if correct, tears the heart out of fundamental research. No amount of fundamental analysis, including the exhaustive high-priced studies done by major Wall Street brokerage houses, will give investors an edge. If enough buyers and sellers have correctiy evaluated new information, under- and overvalued stocks will be rare indeed.

The implications are sweeping. If youre in the market, the theory tells you to buy and hold rather than trade a lot. Trading increases your commissions without increasing your return. It also tells you to assume that investors who have outperformed the market in the past were just plain lucky and that you have no reason to beheve they will continue to do so.»

The semi-strong form also contends that no mutual fund, money manager, or individual investor, no matter how sophisticated, can beat the market using public information. If one does, its pure chance.

Finally, there is the strong form of the efficient market hypothesis. This form claims that no information, including that known by -rate insiders or by specialists trading the companys stock (who have confidential material about unexecuted orders on their "books"), can help you outperform the market. In the few studies done to date, some evidence has surfaced that both insiders and specialists display an ability to beat the market. However, the strong form of EMH is generally considered too extreme, and is not widely accepted.

EMH was also supported by studies that indicated mutual funds and other monies managed by professionals did not outperform the market. Eugene Fama, the leading advocate of EMH (Fortune magazine referred to him as the Solomon of stocks), reviewed the literature and development of EMH in December 1991. Famas report was thorough, covering hundreds of papers published since his last major review twenty years earlier.

Despite the thousands of papers in the last two decades, relatively little new research supporting the efficient market hypothesis has been