Introduction

For the novice investor, one key theory to understand is the Efficient Markets Theory. EMT posits that financial markets are efficient, meaning that asset prices fully reflect all available information. The theory was developed by economist Eugene Fama in the 1960s, for which he won the Nobel prize in 2013. The Efficient Markets Theory (EMT) is closely linked to the CAPM model, about which we wrote last week. Understanding both can make you help make better investment decisions.

In this article, we'll delve into the Efficient Markets Theory and discuss why it suggests that investors should consider passive investing, such as Exchange-Traded Funds (ETFs), as a wise choice for their portfolios.

Understanding the Efficient Markets Theory

The Efficient Markets Theory is built on the idea that asset prices reflect all available information. As a result, it is nearly impossible for investors to consistently outperform the market on a risk-adjusted basis. Stock picking through fundamental or technical analysis is a waste of time, given neither can produce risk-adjusted excess returns (alpha) consistently.

Implications for Active Investing

If the Efficient Markets Theory holds true, it implies that active investing strategies will not outperform passive investment strategies. Why? Because if all available information is already priced into securities, it is impossible to consistently identify undervalued or overvalued assets. This means that even professional fund managers would struggle to achieve consistent outperformance, especially when accounting for fees and transaction costs.

As we have written before, there is a large volume of evidence that supports this claim. Both retail and professional investors often overestimate their own abilities. Most professional active fund managers underperform the market after fees.

There is of course, the Warren Buffett factor: given he managed to outperform the index consistently over multiple decades, it is said that his track record negates the Efficient Markets Theory. However, even if a select few professional investors manage to beat the market consistently, the lesson for retail investors remains the same: investing as if the Efficient Markets Theory is always true will likely lead you to achieve better investment results.

The Rise of Passive Investing and ETFs

Given the challenges of active investing in an efficient market, passive investing has gained substantial popularity. Passive investors aim to replicate the performance of a market index rather than trying to outperform it. ETFs have emerged as the preferred investment product for passive investors. These funds offer diversified exposure to a broad range of assets, such as stocks, bonds, and commodities, while typically charging lower fees compared to actively managed mutual funds.

ETFs align perfectly with the principles of the Efficient Markets Theory for several reasons:

1. No stock picking: by investing in a broad market ETF, you are foregoing stock picking. You accept that you cannot consistently outsmart the market. Instead, you accept the market price and the expected market return.

2. Diversification: ETFs provide you with instant diversification across a particular asset class or market index. This diversification helps mitigate individual (idiosyncratic) stock risk, for which you are not compensated according to the CAPM model. This which is crucial in an efficient market where prices already reflect all available information.

3. Low Costs: Passive investing, often facilitated through ETFs, typically involves lower fees than actively managed funds. Since EMT implies that attempting to beat the market is futile in the long run, lower fees can significantly impact an investor's overall returns.

Conclusion

The Efficient Markets Theory provides compelling arguments for passive investing, particularly through instruments like ETFs. In an environment where asset prices swiftly reflect all available information, attempting to outsmart the market becomes a fool’s errand. The exceptional track record of a few unique investors such as Warren Buffett does not imply that you should spend your time picking stocks. For retail investors, investing as if the Efficient Markets Theory is always true will likely lead you to achieve better investment results. For investors seeking a cost-effective, diversified, and efficient way to participate in financial markets, ETFs are the best tools to build long-term wealth.