As we design recommend portfolios for clients, the overriding premise for each is that markets work.
A freely functioning market does a good job of setting prices for the underlying securities. Investors in equities should expect to receive a reasonable reward for taking risks over the long run. Indeed, long term investors in U.S. equities have been rewarded with, on average, a 10% rate of return going back to the 1920’s. Importantly, this expected return is not tied to selecting the right stocks or timing when to get into or out of the market. It has come from consistent participation in the market – through good times and bad – as the reward for supplying capital to companies they need to fund their growth.
The efficient market hypothesis (EMH) is the key principle for understanding how markets work and what investors should care about. Nobel Prize winning Professor Eugene F. Fama of the University of Chicago, after extensive research on stock price patterns, developed the efficient markets hypothesis which asserts that:
- Securities prices reflect all available information and expectations
- Current prices are the best approximation of intrinsic value
- Price changes are due to unforeseen events
- Although stocks may be mispriced at times, this condition is hard to recognize
The efficient market hypothesis implies, then, that no investor will consistently outperform the stock market, except by chance. That’s because if and when stocks become momentarily mispriced, market forces quickly push prices back toward their fair value. Over any period of time, some investors – or investment managers – will beat the market, but the number will be no greater than expected by chance. The odds are similarly small in identifying who those “lucky” individuals will be ahead of time.