There is a lot of debate in finance about the Efficient Market Hypothesis, and to what extent it applies to real markets. I’m generally an efficient markets proponent, but that’s not what this article is about. What I’d like to discuss is a lesser known side-effect of the Efficient Market Hypothesis that no one really talks about.
The Efficient Market Hypothesis Cuts both Ways
The efficient market hypothesis states that information about a particular security is fully priced into the security. There are a few forms of the hypothesis that vary based on what kind of information is available and priced in. But that’s the essence of it. Prices reflect all available information already.
It’s just as hard to be consistently bad at stock picking as it is to be consistently good at stock picking.
This means that it’s very difficult to use information to develop a trading strategy that reliably and consistently achieves above-market performance. Under the hypothesis, any out-performance is simply luck and is unlikely to persist. This ends up being a pillar of the passive investing philosophy. If you can’t reliably beat the market, then it makes sense to just accept the market return, and pay as little fees as possible.
What about the flip side?
However! The opposite statement is also an important corollary of the efficient market hypothesis. The hypothesis tells us that all available information is already reflected in the price. This means that the current price is as close to right as we can get with the information we have. This also means that it’s really hard to screw up buying a security.
In fact, under the efficient market hypothesis, you can just randomly buy and sell stocks and other securities, and your expected return will be the market return, less transaction fees, plus a random error term. The exact same return you should expect for any strategy, no matter how good the strategy seems. It’s just as hard to be consistently bad at stock picking as it is to be consistently good at stock picking.
Being bad at stock picking is very very close to being good at stock picking
In fact, if you can imagine someone who is consistently bad at stock picking, you’re imagining a person who is 95% of the way to a consistently good investment strategy. All they have to do is multiply all of their signal outputs by -1 and now they have the correct model.
In other words, someone who has figured out how to consistently underperform the market has succeeded in identifying information that is not already priced into the security. They have already found the secret sauce. They’re just applying this information backwards. There’s a scene in Seinfeld where George realizes that all of his instincts are wrong, and thus he will act correctly if he always acts in opposition to his instincts. This is the situation of a perpetually underperforming investor.
This isn’t the reason that people underperform
In reality, people don’t underperform markets because they have backwards strategies. They underperform because they bleed money to high fees and transaction costs. But I think it’s a cool way to think about efficient markets.
It’s just as difficult to be bad, as it is to be good!