Wednesday, December 5, 2012

It Works ... Until it Doesn't

In a recent blog post, economist Tim Harford does a great job explaining the Efficient Markets Hypothesis (EMH), which is one of the concepts that underlies our investment philosophy:
"The EMH has various forms, but in brief its message is very simple: an individual investor cannot reliably outperform financial markets. The reasoning is equally simple: money doesn't get left around on the pavement for very long. If it was obvious that the stock market would rise tomorrow, investors would buy shares immediately and the stock market would rise today instead. Anything that could reasonably be anticipated already has been anticipated, and so markets instead respond only to genuinely unexpected news."
He then goes on to give examples of where the EMH appears to be false, but then on closer inspection, not so much.  We have never claimed that the EMH provides a perfect view of market activity, just that it is true enough to suggest that attempts at beating the market have a high probability of failure.  Again, here's a quote from Tim Harford:
"The efficient markets hypothesis is surely false. What is striking is that it is very close to being true. For the Warren Buffetts of the world, “almost true” is not true at all. For the rest of us, beating the market remains an elusive dream."
One reason for bringing up the EMH at this time is that I recently saw this article in the Economist about the death of the "Fed Model".  The Fed Model was used back in the late 90's as reasoning for the then growing stock market bubble. I won't bore you with the details, but the theory basically said that there was a direct relationship between equity earnings yields and interest rates.  As the chart below shows, this relationship looked pretty solid ... until it didn't:

This is the crux of the problem when it comes to determining an investment strategy. Just because something looks great when we apply it to past data does not mean that it will work well into the future.  Much of economic theory is tested using the concept of ceteris paribus translated to "all other things being equal or held constant" wheras a variable is tested while other variables are held constant. This is a very helpful concept in an academic setting.  However, in the real word, all things are never equal, and the economy and financial markets are complex systems that are ever changing.  That it why we believe the best way to create an investment plan is to apply simply stated concepts such as "risk and return are related" and "markets are fairly efficient". We then implement the plan in a way more focused on things we can control, such as investment costs, as opposed to attempting to "beat the market"       ~ FSB