There is an old story about a financial economist and passionate defender of the efficient markets hypothesis (EMH) who was walking down the street with a friend.
The friend stops and says, "Look, there is a $20 bill on the ground!"
The economist turns and coolly replies, "Can't be. If there was a $20 bill on the ground, somebody would have already picked it up."
This "joke," told by those that believe that the markets are inefficient and that investors can thus outperform the market by exploiting mispricings, is actually a very misleading analogy to the EMH. The following is a much better analogy:
A financial economist and passionate defender of the efficient markets hypothesis (EMH) was walking down the street with a friend. The friend stops and says, "Look, there's a $20 bill on the ground."
The economist turns and says, "Boy, this must be our lucky day! Better pick that up quick because the market is so efficient it won't be there for very long. Finding a $20 bill lying around happens so infrequently that it would be foolish to spend our time searching for more of them. Certainly, after assigning a value to the time spent in the effort, an 'investment' in trying to find money lying on the street just waiting to be picked up would be a poor one. I am also certainly not aware of lots of people, if any, getting rich mining beaches with metal detectors."
When he had finished they both look down and the $20 bill was gone!
What those who tell the first version of the story fail to understand is that an efficient market does not mean that there cannot be a $20 bill lying around. Instead, it is so unlikely to find one that it does not pay to go looking for them-the costs of the effort are highly likely to exceed the benefits. Also note that if it became known that there were lots of $20 bills to be found in a certain area, then everyone would be there to compete to find them, reducing the likelihood of achieving an appropriate "return on investment."
The analogy to the EMH is that it's not impossible to uncover an anomaly (that $20 bill lying on the floor) that can be exploited. Instead, one of the fundamental tenets of the EMH is that in a competitive financial environment, successful trading strategies self-destruct because they are self-limiting. When they are discovered they are eliminated by the very act of exploiting the strategy. Economics professors Dwight Lee and James Verbrugge of the University of Georgia explain the power of the efficient markets theory in the following manner:
'The efficient markets theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear efficient market anomaly is discovered, the behavior (or lack of behavior) that gives rise to it will tend to be eliminated by competition among investors for higher returns. (For example) If stock prices are found to follow predictable seasonal patterns this knowledge will elicit responses that have the effect of eliminating the very patterns that they were designed exploit. The implication is striking. The more empirical flaws that are discovered in the efficient markets theory the more robust the theory becomes. (In effect) Those who do the most to ensure that the efficient market theory remains fundamental to our understanding of financial economics are not its intellectual defenders, but those mounting the most serious empirical assault against it." (1)
In summary, while the markets may not be perfectly efficient (it is possible to find a $20 bill waiting to be picked up), the prudent investment strategy is to behave as if they were. Investors that accept the EMH as fundamental to their investment strategy don't have to spend their time searching for the very few $20 bills lying on the ground. Instead they earn market returns, less very low costs, based on the amount of risk (their asset allocation) they are willing to accept. They also get to spend their time on much more productive and important things like their family, community service, reading a good book, or whatever other "big rocks" there are in their lives.
(1) Dwight Lee and James Verbrugge, "The Efficient Market Theory Thrives on Criticism," Journal of Applied Corporate Finance, Spring 1996.
Larry Swedroe is the author of "What Wall Street Doesn't Want You to Know," "The Only Guide To A Winning Investment Strategy You Will Ever Need," "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," and " The Successful Investor Today: 14 Simple Truths You Must Know When You Invest." Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.