What the Efficient Market Hypothesis (EMH) is missing!

EMHNotwithstanding all discordant evidence to the contrary, the financial services industry insists financial markets are efficient. In an efficient market, according to the Efficient Market Hypothesis (EMH), attempting to sort the skillful practitioner from the lucky is an exercise in futility because the investment returns extracted from an efficient market will reflect the risk assumed, net of costs.

When confronted by an individual with a long term, above average experience – say 15 or more years – those who champion EMH simply instruct the unenlightened that if one were to look at a sufficiently large sample, some percentage of the group will provide a superior result, but still by virtue of chance. Following the logic of EMH, proponents conclude that since it is not possible to predict who will be lucky, one is best served by buying a low cost index fund.

Ignoring Reality

Overall I believe an index approach is fundamentally sound advice for most would-be investors, but not for the reasons articulated by EMH adherents. The problem with EMH is it ignores two critical realities. First, in all human endeavors that I can think of there have always been some practitioners who express superior talents and skills. Why would this not be true for investing? Second, because investing is a probabilistic endeavor – like poker – one can readily identify some individuals who are able to reliably provide superior results. Why would this not also be true for investing? Taken together – unique talents and the existence of superior performers – it suggests there may be something at work that devotees of EMH are missing.

I propose that elite performers, irrespective of discipline, have more in common with each other than they have with the less successful practitioners within their discipline. In other words, there is something that is remarkably consistent between individuals with unique talents, who are also superior performers, irrespective of calling.

The Elite Performers

Investing is a discipline rooted in probabilities. While most professional investors acknowledge this point – at least at some level – few appear to operate in a manner consistent with this understanding. According to Michael Mauboussin, Chief Investment Strategist of Legg Mason Capital Management and Adjunct Professor of Finance at Columbia Business School, the best performers in probabilistic endeavors have three common and consistent approaches.

1. Focus on process over outcome. While success will ultimately be measured through outcome, what is acknowledged by elite performers is the importance of sequence: a correct and superior process is what gives rise to a superior outcome. The impostor investor usually has this sequence in reverse, affording primacy to outcome. The elite practitioner recognizes that a poor process may result in a good experience (luck), but a consistent application of a poor process will ultimately end in failure (poetic justice). Alternatively, an excellent process may result in a poor experience (bad luck), but a consistent application of an excellent process will ultimately end in deserved success (poetic justice).

If a process is sound it should maximize objectives over time. On a craps table it may mean reducing the house’s edge by some percentage. In investing, the process should do two things: identify safe prospective investments first, and then focus on the likelihood of positive expected returns.

Most investors have this process backwards. For these folks investing is about comparing today’s alternatives, based on their experiences of the past to predict the future. This can be a very risky endeavor. Unless you were a recluse, impostor investors throughout the 1990s could not help but learn of the easy riches secured by those “playing” the stock market – particularly those choosing to bet on those companies involved in high tech, telecommunications and companies identified as large cap growth. Observing the recent past is so much easier than executing a disciplined, analytical process. The higher these stocks climbed throughout the 1990s the more confident the impostor investor became. A bubble was in the making and a pin was lying in wait.

It is interesting to note how human genetics influences backward thinking. The limbic system (a more primitive part of the brain) processes short term thinking, while the prefrontal cortex (a more evolved part of the brain associated with planning) deals with persistence, determination and patience to achieve long term results. It is always a good idea to start one’s diet, tomorrow. It is always easier, and more pleasurable, to buy stocks that are advancing with the greatest resolve than to labor and load up on stocks that may require five to seven years to provide a reward.

When statisticians speak about a “statically sound” system they mean the system is highly correlated to the underlying probabilities and outcomes. In some systems the probabilities are more stable, as in blackjack. In complex adaptive systems, like investment markets, statistical probabilities change over time. In still other complex systems, like certain kinds of “super catastrophe” insurance, the probabilities and outcomes are highly obscure. Demanding increasing margins of safety as systems become less predictable just makes sense.

When professional statisticians speak about an “economically sound” system they mean the player’s decisions are designed to maximize value, over time. In investing we seek safe opportunities (as measured by the balance sheet) with realistic positive expected returns. Notice, like poker, we are not trying to maximize the number of winning hands. Rather, we are trying to make the most money by maximizing a return opportunity – to, in the words of Charlie Munger, “back up the truck” – when the opportunity presents itself.

Within this context, broad diversification makes little sense. Our portfolios are typically targeted to be fully invested with 20 to 40 positions. By the standards of the financial services industry, our concentrated portfolios are considered foolish, if not irresponsible. From our perspective, and in marked contrast to the financial services industry, any competent money manager would not willingly dilute his 20-40 most compelling selections with 60 or more inferior opportunities.

Professional poker player David Sklansky expressed the forgoing process vs. outcome paradigm in his book The Theory of Poker, “Any time you make a bet with the best of it,” explained Mr. Sklansky, “where the odds are in your favor, you have earned something whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.”

While many professional investors celebrate the virtues of a long-term disciplined investment strategy, their actions reflect an approach focused on short-term trading, buying what is in vogue, and obsessively tracking benchmarks. Failure is inevitable.

I love the following quote by the 1972 World Series of Poker winner Amarillo Slim because he captures the essence of process, “The result of one particular game doesn’t mean a damn thing, and that’s why one of my mantras has always been, ‘Decisions, not results.’ Do the right thing enough times and the results will take care of themselves in the long run.”

2. Tipping the Odds in One’s Favor. Those involved in probabilistic endeavors typically have ample opportunities to pursue their trade; hands of poker, balls thrown to the batter, stocks for investors. In the investment discipline articulated by Dr. Graham, the investor is essentially admonished to seek gaps between current and future expectations. If a business has a strong balance sheet and even only average prospects, but the stock is priced as though the business is about to file a bankruptcy petition, the risk/reward odds of such a situation are excellent. Populate a portfolio with between 20 to 40 such opportunities and a pleasant experience will be a likely outcome.

3. Diversification by Time. If an investor acquires a security due to its fundamental merits, judged safe by virtue of its balance sheet and its discount from assessed intrinsic value, such an investor has assumed time risk but not value risk. Typically in situations where near term prospects are under a cloud, management is scrambling to remedy its difficulties. In these kinds of situations it is not uncommon for turnarounds to occur faster than expected. Thus, the patient investor who plans to wait five to seven years for the investment to work out often reaps the benefits of early value realization. In effect, the long term investor with a long term focus gets a free call option on a short term turnaround.

In October of 1987 it did not matter if an investor had 20 stocks or 220 stocks, his/her portfolio fell by about 25% in a single day. But if the investor did not panic, and held his/her stocks for the following approximately 15 months, the investor was made whole. In this past century’s largest one day collapse, it was not the breadth of a stock portfolio that cancelled each other out, it was the days. This is but one reason why we do not like leverage – we never want to be forced to forfeit such a powerful long term advantage.

So short term traders, and momentum investors, can outperform others for a time. But investors of these sorts have to get their timing correct virtually all of the time to succeed. One mistake and the mathematics of a blunder may transform all victories into a defeat – winning many battles but losing the war, as it were. A 50% decline requires a 100% return to simply break even, and that’s before transaction costs and tax effects. ($100 – 50% = $50. For $50 to return to $100 the security has to advance 100 %.) But for long term investors, those who are prepared to wait for five (or more) years, the returns become meaningful, and tax efficient. If the investment thesis is correct, such an investor will do well over the long term and receive a free call option on a short term turnaround.

You can see why so few investors would even consider applying Dr. Graham’s strategy. The vast majority of investors demand immediate results; nor can the vast majority of investors tolerate short term pain. For folks like us it means we must endure the discomfort of acquiring a stock that has fallen to a level that is sufficiently attractive to get our attention, and likely to continue to decline as we build our position. Of course, our willingness to sustain this short term pain is also the best hurdle I know to ward off the competition.

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