Efficient market hypothesis says that financial markets efficiently process all publicly disclosed information in order to arrive at correct prices for all commodities (stocks) at all times. Thus, if efficient market hypothesis is true every stock in the market is priced correctly and it is impossible to pick up any bargains. That is, it is impossible to consistently beat the market. Efficient market hypothesis is something of a paradox. If it is true then there is no point in traders and investors making any effort to beat the market. They may as well just buy every stock in an index and spend their time doing something else. But, it is only the fact that many individuals, and many of these highly intelligent graduates using state of the art computer models, do try extremely hard to beat markets that makes them efficient. Markets ARE efficient. The actions of so many people, informed by an unprecedented volume of timely information, and mediated by instantaneous technological platforms mean that prices really do reflect just about all there is to know about a particular stock and the wider conditions in which it operates. BUT... Markets are not perfectly efficient. Prices do not conform to some well-defined mathematical formula, but instead reflect to a considerable degree the psychology of market participants. Consider market crashes that have occurred throughout trading history. Or the wild ups and downs seen in mid-2006. Can a the market really be correctly priced at one level today, and also correctly priced at substantially less tomorrow? An alternative to efficient market hypothesis is random walk theory. This says that while markets may not be perfectly efficient, it is still not possible to consistently beat them because they are inherently unpredictable. Much like a drunk trying to find his way home, they follow a random walk. Whichever theory is true - efficient markets or random walk - the corollary is that it is impossible to consistently beat markets even with perfect knowledge and perfect analysis. This means that managed funds should be bad for your wealth, ie after deduction of the manager's fees they will actually UNDERPERFORM the market as a whole. Of course, a few fund managers can point to consistently above average performance. Is this down to skill? Not necessarily, more likely luck. If you sit enough chimpanzees at typewriters and get them to bash away, one or two might actually produce intelligible words. However this is just due to the law of averages, rather than the linguistic ability of the subjects. In any case if someone really were able to beat the markets don't you think they'd be doing it for themselves rather than altruistically using their talents for others? Unless of course the fees they charged were more than the profits they could produce. For more on this fascinating topic see Burton Malkiel's excellent A Random Walk Down Wall Street. So, it's better to simply invest in a low-fee tracker fund (or several, if you wish to spread your investment across different regions/sectors). Trackers mean you miss the excitement/headache of stock-picking (depending on your point of view) but will yield healthy growth in the long run. You still get to choose which index(es) to invest in. At the core of almost everyone's portfolio should be the major companies (blue chips) of their home country. Beyond that, why not follow your instincts by gaining exposure to some specialized indexes of your choice. If you really want to have some fun then rather than trusting your hard-earned cash to a faceless manager, why not pick some stocks of your own. Do some research by all means, but remember the market price probably already reflects what you find (and more). At the end of the day if you are going to beat the market you need to rely on your intuition, that little voice within that tells you a stock is right for you. |
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