Are Markets Efficient and does it matter?

A lot of investing debate and styles of investing are supposed to emanate from this question. The roots of this debate are in an old financial theory called the Efficient Market Hypothesis – which says that all that is to know about a stock is reflected in its price at any point in time, so it is futile to analyze stocks as no one can do it. The very theory challenges human nature so much that it is no surprise that, depending on who you are and what your place is in the financial services industry, you are almost compelled to take a view on it – one way or the other.

marketefficient-garfield_dont_care_black_shirtBut for an individual investor, is it really relevant? Does it matter whether markets are efficient or not, or is it just another debate to confuse him? Again – like so many other things in investing, this may be a great question for experts to debate on, but for an individual investor, a wrong question with many right answers. For an individual investor, letting go on this debate on whether markets are efficient is the best choice. “I don’t know” and “It doesn’t matter” are the best responses. The answer to this question is said to determine whether you as an individual or a fund manager who manages your money can beat the market or not. Again – this is perhaps the wrong question. What if I decide that the markets are efficient and hence invest in Index funds, and then later (at the end of  a year or two) realize that there are lots of funds beating the Index? On the other hand, what if I decide the market are not efficient and hence invest in an Actively Managed fund or decide to manage my money myself, and then later realize that it has not beaten the Index? In other words, the market turned out to be not efficient, but so did my fund manager and my investing techniques!

So actually the prudent answer for an individual investor to the question on whether the markets are efficient or whether I or my fund manager can beat the Index is “I don’t know and it doesn’t matter”. Because the reality is, irrespective of whether they are efficient or not, it is practically impossible to predict in advance whether and/or which stock or which fund manager will beat an Index. Hence – “I don’t know and it doesn’t matter”. Well – I don’t know is fine, but an individual investor may ask why “it doesn’t matter”? It doesn’t matter because what matters more is to have an investment plan, asset allocation and re-balancing strategy in place. What forms part of those assets once you have a plan in place does not matter that much. So whether you choose an Index fund, or an individual stock or an actively managed fund within that asset allocation and re-balancing plan based on your answer to the question “Are markets efficient” may not matter much, at least if you are broadly close to market averages, and in so far as reaching your financial goals are concerned.

So – leave the debate of whether market are efficient to the experts to fight over and resolve. Post that, let them decide whether to focus on large caps versus mid caps; or to use fundamental analysis or technical analysis. For you as an individual investor, what matters more is a proper investment plan to reach your goals that is in line with risk profile, has the right asset allocation and re-balancing strategy in place, and the discipline to stick to it. Post that, you are free to keep deciding what assets to put into that plan, based on performance every year or every couple of years. If the markets turn out be efficient, you are free to move the actively managed fund and individual stocks out of that plan, and hold an Index fund.  If the markets are not efficient and you end up with a good fund manager (or if you yourself are able to beat the market) , good for you, as the stocks and funds you hold may beat the Index. And finally, if you realize that markets are not efficient, but your investment style or fund manager turn out to be equally inefficient :-), you are free to move that money to an Index fund!

So let the debate on Market Efficiency continue, and let the experts argue and make a case for your money. You as an individual investor are in an enviable position, because when asked your view, you can continue saying – “I don’t know and it doesn’t matter.”

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Buffett’s style can’t be implemented by Mutual funds fully, but it does not matter

It is structurally not possible for mutual funds to implement value investing, in its completeness.

Mutual funds are essentially slaves of their investors and their temperament. Simply because of the structure of mutual funds and the need to beat an index on a monthly, quarterly, annual basis, it is almost impossible for mutual funds to replicate the ‘buy value and hold long term as long as the business stays great’ approach of Buffett in toto. And there is no reason honestly for individual investors to put their money in actively managed mutual funds if they cannot beat the index. That in itself is a structural constraint on why mutual funds will never be able to fully implement Buffett’s value investing style.

But nevertheless, I think individual investors may be in a position of advantage here, if they manage their portfolio well,  simply because of the situation that mutual funds find themselves structurally in.

One option for value oriented individual investors is clearly by not investing using mutual funds and doing value investing in a full fledged manner by directly buying stocks of great businesses at good prices and holding them, aka Buffett. But that may work for only a select few who want to do investing full-time, and may not be feasible for most individual investors. But even though most individual investors may not be able to do this, the second option for value-oriented individual investors may actually be to treat mutual funds as ‘diversified value buckets’, use them as useful stock selection mechanisms, and buy (more or less) mutual fund units based on their general assessment of value existing the market at various times.

That’s one way that individual investors can perhaps be value investors in a partial sense, without having to dabble directly in stocks – but by using funds as proxy value buckets. The need of funds to constantly beat indexes will make sure that they get at least reasonable performance (else use index funds), and treating funds as value buckets will ensure that investors can practice value investing, though to a lesser extent than Buffett, and buy general market value by timing their purchase of fund units.

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