Our analysts will uncover the best stocks to buy. The chart on that stock forecasts a breakout to new highs. Our mutual fund beats the market because our manager is really, really smart. Sure, and the check is in the mail.
It is simply amazing that 40-plus years after academic investment researchers began poking holes in Wall Street’s unsupported claims that so many investors still fall for them. Way back in the 1960s, when punch card readers outnumbered computers, the efficient markets and random walk theories began to gain academic support.
Today piles of studies confirm their findings, which conclude it is a worthless exercise for most investors to spend time and effort trying to beat the market. Investors who still think it is their job to analyze the stock market, industries, or individual stocks should learn about the theory of random walks first; it may save them a lot of time and money. One of the most accessible introductions was written back in the 1960s by Professor Eugene F. Fama of the University of Chicago. Fama is a major contributor to random walk theory. His paper, “Random Walks in Stock-Market Prices,” is available for free on the University’s graduate school web site at gsb.uchicago.edu/pdf/sp16.pdf.
Markets are efficient consumers of public information, according to random walk theory. They are dominated by large numbers of intelligent investors who compete actively to make money. The intense competition among participants means that all information is very quickly priced into the market. But that doesn’t mean that every stock is priced exactly according to its proper intrinsic value. Market participants will still disagree about the proper price. That’s the insidious part—their disagreements about proper price will cause the price to randomly wander around its intrinsic value.
Even worse for someone who is analyzing a stock in order to predict its future performance, new information will be quickly digested by market participants, but even so the adjustment to intrinsic price won’t happen predictably: “Actual prices will initially over adjust to changes in intrinsic values as often as they will under adjust,” Fama wrote. That makes the process of price adjustment unpredictable. Today’s prices will be useless in predicting tomorrow’s prices, he added: “A series of stock price changes has no memory.”
Now the real world may not operate quite this way: there may be some dependence of future prices on current prices. But efficient market theory says that price dependence won’t be enough to capitalize on: the time and cost of analysis and trading will not produce enough extra return over a simple buy-and-hold strategy, Fama argued.
Efficient market theorists concede that there may be a few analysts who are smart enough to identify wide discrepancies between market prices and intrinsic values and who can act on them before others do. However, their actions, while profitable to themselves, will narrow discrepancies between prices and intrinsic values, thereby making the market more efficient and reducing the chance for everyone else to make money by active stock selection or timing.
There is little evidence that most money managers can beat the market by more than chance. Studies of mutual funds show this to be the case, Fama wrote.
