EMT

Actually, in its purest (or strongest) form EMH almost certainly does not exist and is rather just a "utopia" of assumptions. It is similar to a "perfectly competitive market" in microecon. It is important to understand that most theorists do not believe we operate in a perfectly efficient market. EMH only outlines the rules for an efficient market and is often used for study/analysis in acedemics to prevent overcomplication and undue influence from unmeasureable variables.

Both ideals require, among other things, all available information delivered instantaneously to market participants. One of the most overt evidences of this is market bubbles and crashes. A perfectly informed investor would recognize a bubble build-up and immediately take an opposing position that would in turn help reduce the overinflation of the bubble itself. If ALL investors were perfectly informed, as assumed in the EMH, the bubble would never burst due to the recognition of the bubble and the opposing positions that mitigate it. As a matter of fact, the bubble would never form. A bubble/crash is really nothing more than investors acting on bad information, assumptions, rationalizations, lies, and/or hopes long enough to cause the market to be heavily tipped in one direction. EVENTUALLY, everyone realizes this and jumps to the other side to correct (and often end up overcorrecting).

Buffet and Lynch outperform the market because they invest in markets where the information (publicly available or not, I can't say) is not accurately reflected in stock price. That also reminds me, insider trading and "hot stock tips" (particularly when they are never discovered) are two of the best examples of EMH malfunction. Because the diffusion of information trickles down and is not immediately released upon the entire market at once, a few are able to benefit from information that should be reflected in stock price, but is not yet.

There are actually three degrees to the EMH, each one being less restrictive. In reality our market probably operates as a weak-form EMH and we are striving towards a strong-form EMH.

Reply to
kastnna
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"Will Trice" wrote

Nope, not you. ;-)

I agree the original post and its follow ups were fine, except for the nigglingly incorrect subject line, which I have now repaired. Want to argue about it? :-)

Reply to
Elle

I've seen it called both a theory and a hypothesis. The OP called it both. I wonder which is more common?

-Will

Reply to
Will Trice

"efficient market hypothesis" = 182,000 google hits "efficient market theory" = 67,300 google hits.

I'm with Elle on this, although I didn't give it much thought till she brought it to our attention. JOE

Reply to
joetaxpayer

(small cap and value effects)

There are (at least) 2 as yet unexplained anomalies in Efficient Markets theorem:

- small capitalisation stocks outperform large capitalisation stocks

- 'value' stocks (usually measured as Market Cap to Book Value, but we would think of it as Price to Book) on a number of criteria outperform 'growth' stocks by a substantial margin

Neither of these anomalies appears to be fully explained by higher volatility of returns. In the case of the Small Cap effect, it may be entirely an artefact of the data, (investors couldn't actually trade those stocks, at those prices, they are too illiquid).

There are other unexplained anomalies (January effect, closed end company effect), equity risk premium puzzle (equities have returned much higher over the last 100 years than theory would predict).

Nonetheless the small cap effect and the value effect are the ones that most vex the finance researchers.

Warren Buffet it is best to view as a private equity investor-- he substantially deals in unlisted companies. Most PE firms underpform an

*equivalently levered* index of the SP500 (ie an SP500 with 80% borrowing). But a significant portion of PE firms do not underperform, and the performance has a tendency to persistence within a firm in successive generations of fund.

(see David Swensen's books for more explication).

It's not really possible for US investors (private individuals) to gain access to top performing PE funds, *except* by investing in certain closed end UK funds (investment trusts) with a good long term record-- names to research include 3i, Candover, Electra, Permira, HG Capital. It's also worth knowing UK private equity returns are likely to be lower in the future than in the present.

KKR and Apollo also launched Dutch Listed Vehicles, but I recommend checking the fees.

Reply to
darkness39

Illiquidity cannot be the only explanation for the outperformance of small cap value companies. While it is true that some of the smallest stocks are highly illiquid, empirical evidence shows that the outperformance of the typical small cap value portfolio does not hinges on the performance of these illiquid stocks. Also, as capital markets develop, this would imply higher liquidity of small cap value stocks, and therefore smaller outperformance of small cap value stocks. There is no evidence of such an effect, if you look at the data

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if the liquidity of small caps were the reason of theiroutperformance, then small growth stocks will also outperform largegrowth stocks. In fact, small growth stocks underperform all otherinvestment styles, including large growth stocks (see
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Reply to
Jose Bailen

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