Adam Ozimek

Hi Adam,
I found your site through an instapundit link and was interested in your numerous links and comments on efficient market theory (EMT). I think you and the other commentators are over-analyzing the concept and making it more rigid than the proponents argue. I’m basing my analysis on Malkiel’s “A Random Walk Down Wall Street.”

Maximum Likelihood Estimator (MLE) is the statistically most accurate prediction of future outcome. For example if you flip a coin, the MLE for the outcome is 1/2 heads and 1/2 tails. If you roll a pair of dice, the MLE for the outcome is 7. In these cases, we have perfect knowledge of the system and can calculate the odds of each outcome. This same approach can be easily applied to continuous probability distributions. With some caveats, MLE can also be applied to empirical data when we don’t have true knowledge of the system we are examining.

EMT states that for a naive investor, the current price of the stock is the MLE of its future price. PERIOD.

Will these prices go up and down? Of course. Are some stocks undervalued? Of course. Are some stocks overvalued? Of course. If you have more knowledge about a company, its competitors, its markets and significant trends, can you more accurately predict its likely future price? Again, of course.

EMT does not state that knowledgable insiders won’t do better than throwing darts. It does state that rate at which insider information propagates through the market is so fast that the by the time the naive investor finds out about a trend, the current price already reflects the sophisticated investor’s knowledge of the expected trend (Malkiel goes over this in some detail in his book). By trying to follow the market trends, the naive non-EMT investor is actually doing worse than pure chance (he is literally buying high and selling low).

Can an individual investor do better than EMT? Sure. Benjamin Graham’s value investors like Warren Buffett will usually outperform EMT investments like Vanguard. You can do the same analysis as Berkshire and reap the same rewards, but it demands a lot of work. In practice, most mutual fund managers are not Buffett’s league, and they perform no better than throwing darts (and often much worse).

For EMT to work, a significant fraction (perhaps 5 to 10%) of the people buying and selling in the stock market must be working hard to acquire stocks that will gain in value and shed those that will decline. There will never be a shortage of these hard working investors since they will reap a significantly larger reward than the EMT investors. The beauty of EMT is that you can achieve 80% of the return of the knowledgable investors who spend thousands of hours in research and analysis per year for 3 or 4 hours of work balancing your portfolio each year. I fully understand the hatred directed at EMT by brokers, mutual fund managers, and investment counselors since if it is correct, they are entirely useless parasites on investors. EMT investors gain by removing emotion, decision making under stress, trading fees and active management fees while consistently performing in the 80th percentile of mutual funds.

As a long term EMT investor (over 25 years), I am sure that you, or some other fund manager can outperform an index fund (Benjamin Grahan, Warren Buffett, and Peter Lynch all did so). Further, if you are able to outperform index funds, you should be lavishly rewarded for hard work you put in and the wealth you create. For me EMT yields the highest return on investment for the time I devote to it.