Monday, 22 November 2004

Efficient Market Theory at The Big Picture

Barry Ritholtz at The Big Picture looks at the Efficient Market Theory. In particular, I think the following excerpt has particular relevance for the revamp of the investment philosophy for retirement programmes like the Social Security and Singapore’s Central Provident Fund.

EMH proponents suggest most participants would be better off owning index funds -- something I agree with for many time constrained or uninterested investors. By definition, if someone is outperforming, then someone else is under-performing. The odds favor that its more likely to be a small private investor (not that institutional players don't stink up the joint). Over time, money flees professionals who consistently under-perform. The same ruthless Darwinian competition that drives pros out of business merely makes lousy individual investors poorer.

He also provided an excerpt from a WSJ article:

In a study of Sweden's efforts to privatize its retirement system, Mr. Thaler found that Swedish investors tended to pile into risky technology stocks and invested too heavily in domestic stocks. Investors had too many options, which limited their ability to make good decisions, Mr. Thaler concluded. He thinks U.S. reform, if it happens, should be less flexible. "If you give people 456 mutual funds to choose from, they're not going to make great choices," he says.

For all its limitations, the Efficient Market Theory is largely valid. Few people consistently beat the market. Unfortunately, in trying to do so, incompetent amateur investors will become the fodder from which more competent professionals make their money. Others who tend to trade on "noise" will rack up large brokerage costs that more than negate their trading profits.

The odds of beating the market are not high to begin with. For amateurs, it is even more of an uphill battle.

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