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Can’t beat the market? There’s a theory for that

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Another study has confirmed what the Efficient Market Hypothesis (EMH) tells us – that active investment managers are not worth the cost. While these managers can, on average, beat the market slightly, this is dwarfed by their expenses, so the average investor is better off passively investing.

Mispriced assets create an arbitrage opportunity that gives above-normal profits to those who can spot these pricing anomalies. The EMH predicts that in an open and liquid market, investors will try to reap arbitrage profits through buying or selling of the mispriced asset, which will push the price of that asset to one that "incorporate[s] and reflect[s] all relevant information". Efficient market pricing of assets simply does not happen by itself, it is the result of the actions of market participants. Since there are so many investors looking for these arbitrage profits, these above-average returns, in theory, should be small. The study shows that they are small in practice as well. Active investors are not without their uses however, as they are vital in returning assets to their fundamental value.

Even with the EMH there are ways to beat the market; two in particular have been used heavily by Warren Buffett. One is going from a passive provider of capital to working with the company to improve its performance. Another is to find assets that markets largely do not have access to, so EMH forces are muted.

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Before the Facebook IPO , for example, I argued to anyone who would listen that the IPO was likely overvalued, since the investors who had access to the IPO were not representative of the market as a whole. I believed that once the entire market had access to the stock, it would be priced more reasonably. That position was vindicated in the short run, though it may not be in the long run.

Unless you have access to investors others do not, or can influence a company through your managerial talents, trying to beat the Efficient Markets Hypothesis is a fool's errand. As Joshua stated in WarGames, "the only winning move is not to play."

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About the Author

Mike Moffatt is an Assistant Professor in the Business, Economics and Public Policy (BEPP) group at the Richard Ivey School of Business – Western University. Mike also does private sector consulting for the chemical industry. More

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