In this article I'll explode the myth around efficient-market hypothesis and what you'll miss out on if you only invest in index funds.
There are many theories and myths about sharetrading which simply do not work in the real world. Often in the financial world, people take these theories and twist them to suit their own purpose. One of the biggest myths in sharetrading is the efficient-market hypothesis (EMH).
EMH says that security prices at any one time efficiently reflect all publicly available information. Hence, according to the theory, it is not possible to consistently outperform the market by using known information except through luck.
There are three versions of the hypothesis: the weak form EMH, semi-strong form EMH and strong form EMH. While there is significant data to refute the semi-strong form and strong forms, it doesn't stop some from pushing the theory to try and influence investors.
If EMH were true, there should not be such things as bubbles, flash crashes and long opportunities for arbitrage. If markets were efficient there should be no sudden spikes in prices for no reason. Anyone dealing in the market day to day would know these things occur more often than we would like to think. If you need more convincing try reading books like 'Irrational Exberence' by Robert Shiller, 'The Big Short' by Michael Lewis or even books about Warren Buffett or Peter Lynch.
There are many people who don't believe in the efficient market hypothesis. For example, Robert Arnott, John Mauldin, David Dreman and Andrew Smithers.
Yet there are others, particularly followers of index funds (or those who trade with more passive investment strategies), who agree with the EMH. Indeed, index funds are booming. Some who adhere to EMH say that it can be directly attributed to the exponential growth in index funds.
However, think about index investing. Essentially you're replicating an index performance. The problem is that indices are generally weighted for market capitalisation. That means if you buy an index fund you'll have a bias towards growth stocks. So you will miss out on the cheaper value stocks which, over time, have been shown to outperform growth stocks.
In any business transaction, the aim is to buy at a low price and sell even higher. It's the same with value investing. The aim is to identify cheap businesses and then on sell them at a higher price.
Warren Buffett takes this one step further by saying:
"It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
The challenge for all of us is to identify a wonderful company and then secondly, determine a fair price for that company.
Would you buy a one hundred dollar bill for two hundred dollars? Of course not. But a growth investor would, as long as they were confident that they could sell it to someone else for more than $200. Growth investing is not concerned with price. Its motto might be something like "buy high, sell even higher."
There is a place for growth investing. It really comes into fashion in a rising market when investors are willing to take on extra risk. Usually with growth investing you pay high prices in the hope to sell even higher. It's a reflection of optimism.
Often, if you are looking to hold long-term, you want to make sure that the high prices are justified and are followed by strong profit growth.
There are many studies out there which examine which type of stocks – growth or value – perform better. And the results are always the same: value stocks outperform growth stocks.
Common measures used to evaluate value include:
In conclusion, my money is on value investing. You can't deny that more and more people are shifting towards index funds. They give investors the benefit of low fees and diversification. However, if you want to take a more active role to outperform the market, I would weight towards value rather than size.
Happy trading!
Julia Lee Equities Analyst Bell Direct Have you started trading with Bell Direct for just $15 a trade? Register now for free.