Of Course You Can Beat the Market

One of the most delightful things about being American is the middle finger. There is, of course, the physical satisfaction of righteously flipping the bird. Cut off in traffic? Extend it. Grumpy at an opposing sports team? I would recommend the double hand thrust. However, as I learned in my recent trip to Europe, bad drivers are everywhere, and the physical act of shoving your finger into the sky feels just as good in England as it does in New England.

What I’m talking about is the American tendency to flip the bird ideologically. It is rugged individualism, the ridiculously relentless optimism that makes America unique. Perhaps the defining American mindset is looking at terrible odds and thinking, “Meh, I’ll do it anyway.” 

My favorite example of this is building a venture-backed startup. This is a market with a 98% failure rate. 98%! Any sane, rational person would avoid something that fails this often. Despite producing so many flops, America is the technology startup capital of the world. All of the good of silicon chips and computers and genetic technology is only possible because Americans reject the odds. This attitude does make the country chaotic, but it also makes it great. 

However, I feel a tremor in tech—an intellectual wobble, if you will. With the threat of recession and rising interest rates, there's been a cooling of startup ardor. Few people want to admit that they're afraid to pursue the startup dreams they once held. Instead, they point to economically "rational" explanations for their reluctance. A popular framework I often hear cited is the Efficient Market Hypothesis (EMH). 

For the unfamiliar, EMH is an idea from the 1960s from economist Eugene Fama that states that a public stock price perfectly reflects all available information, and therefore consistent alpha generation is impossible. 

I vehemently disagree with this framework. It is dicey in the public markets and borderline dangerous in the context of private markets. You are best served by investing in the opportunities where you have a true competitive edge. These are everywhere. In public markets and in private, alpha abounds. 

When founders and investors buy into EMH, they stop taking shoot-for-the-moon bets because they believe they're too risky or irrational, and the markets always behave rationally. They are selling tomorrow’s better future for the chance of statistically average returns today. If progress is made one middle finger at a time, EMH proponents are sitting on their hands, behaving themselves in Sunday School.

While theoretically the EMH is possible, it does not reflect reality. Markets exist on a spectrum of efficiency, not in absolutes. Understanding when and how to identify inefficiencies in markets is perhaps the most important skill a person can gain. 

Today I would like to argue my case against EMH in two parts:

1. Public markets aren’t efficient.
2. Private markets are even less efficient.

Let’s dive in. 

Why public markets don’t work

To better understand why EMH is so dangerous, it is helpful to examine the definition. EMH states that it is impossible to consistently outperform the market by using publicly available information. This is because asset prices already reflect all available information that would affect their price.

EMH is based on the idea that all investors are rational and will act in their own best interests. They will buy assets when they believe they are undervalued and sell them when they believe they are overvalued. As a result, prices will quickly adjust to reflect new information, making it impossible to consistently beat the market.

I know, I know, that sounds authoritative. It’s a nice, clean, simple view of reality, and it’s comforting to people who believe it. But there are so many issues here!

First, and most importantly, EMH argues that over time stocks are always priced appropriately. This is obviously untrue—just look at underpriced stocks in certain sectors (e.g., tech 10 years ago). EMH doesn’t offer some magic formula for determining how long it will take a stock to be “priced appropriately.” I’m sure Walmart’s stock will be negatively affected by the heat death of the universe, but in the meantime, that doesn’t help me post 10% yearly returns. 

The second error is the assumption that information is priced in. Again, this is, like, totally wrong. There’s debate, even among EMH proponents, about what type and quality of information a public stock price reflects: 

• The weak form of the EMH states that stock prices reflect all past information. 
• The semi-strong form states that stock prices reflect all publicly available information, e.g., SEC filings. 
• The strong form states that stock prices reflect all information, both public and private.