What is the Efficient Market Hypothesis? PLUS ANALYSIS

The ques­tion of whether stock mar­kets are effi­cient is cen­tral to an investor’s choice of invest­ment styles. An effi­cient mar­ket is one where infor­ma­tion affect­ing the price of a stock is rapidly impounded into the share price. In such an envi­ron­ment, the mar­ket price of a stock is an unbi­ased esti­mate of its fair price.

Weak Form Efficiency.

There are three lev­els of mar­ket effi­ciency depend­ing on how we define “infor­ma­tion”. The first level of mar­ket effi­ciency is called weak form effi­ciency. Under weak form effi­ciency, share prices reflect infor­ma­tion con­tained in past mar­ket data such as past stock prices or trans­ac­tion vol­ume. This implies that it is futile to pre­dict the future of a stock based on price charts and tech­ni­cal indicators.

Semi strong form efficient

The sec­ond level of mar­ket effi­ciency is known as semi-strong form effi­ciency. In a mar­ket that is semi-strong strong effi­cient, the cur­rent stock already reflects all pub­l­icy avail­able infor­ma­tion. Such infor­ma­tion include not only past mar­ket data, but also all pub­lic infor­ma­tion about the firm’s fun­da­men­tals such as its profit and loss state­ments, bal­ance sheet, cash flow state­ments , as well as the company’s research and earn­ing fore­casts pro­duced by stock bro­ker­age firms. Semi strong form effi­ciency implies that it is unprof­itable to buy and sell stocks based on infro­ma­tion that is pub­l­icy traded. It is futile to rely on fun­da­men­tal analy­sis to to select stocks for investment.

Strong Form Efficiency

The third and most strin­gent def­i­n­i­tion of effi­ciency is strong form effi­ciency. Under the strong form effi­ciency, the cur­rent stock price reflects all rel­e­vant infor­ma­tion about the firm, regard­less of whether the infor­ma­tion is pub­lic or pri­vate. Hence, inside infor­ma­tion (infor­ma­tion avail­able to a firm’s employ­ees and man­age­ment but not the pub­lic) is included in the def­i­n­i­tion. Strong form eff­ciency implies that no investors, not even those trad­ing ille­gally on insider infor­ma­tion, can con­sis­tently find under­val­ued stocks.

My Per­sonal Opin­ion. (For Local Mar­kets)

This topic of (Effi­cient Mar­ket Hypoth­e­sis )EMH is very closely tied with the invest­ment strat­egy of active or pas­sive. If you use  a active strat­egy , you will pick stocks to your port­fo­lio and buy and sell them as and when you deem it is nec­es­sary. Some peo­ple buy var­i­ous unit trusts and buy and sell them on a reg­u­lar basis.  Note that the aim of the fund man­ager of most unit trusts(except for fixed income and some oth­ers)  is basi­cally to beat the mar­ket index. In Singapore’s con­text, that would be the STI.

Stud­ies have con­sis­tently shown that unit trusts fail to beat the mar­ket returns. I have an research arti­cle of the per­for­mance of unit  trusts in Sin­ga­pore writ­ten by Pro­fes­sor Koh Seng Kee pub­lished in HERE. Although there are many out there who hold invest­ment shares in var­i­ous blue chip com­pa­nies and buy and sell the shares , they usu­ally incur bro­ker­age and trans­ac­tional fees, which make eat into their absolute return (invest­ment return they get at the end).

Hence, a pas­sive strat­egy could pos­si­bly be more appro­pri­ate in Sin­ga­pore. One could basi­cally buy a Exchange Traded Fund ( ETF)

Why invest in STI ETF ? Since the STI ETF tracks the Straits Times Index, we can take a look at the his­tor­i­cal per­for­mance of the STI. STI is a bench­mark that tracks the per­for­mance of stocks in Sin­ga­pore gen­er­ally. The pic­ture below which is taken from fund­su­per­mart, shows the his­tor­i­cal per­for­mance of STI from 1985 up to 2008. The num­bers in the pic­ture indi­cate the onset of bear markets.

Cour­tesy of MoneyTalk.sg

From a region of around 700 points in 1985, it man­aged to touch a high of around 3800 in 2007. The impor­tant point to take note is that STI always rise in the long run as seen from the pic­ture above. Between this period of 1985 and 2007, Sin­ga­pore has faced peri­ods of eco­nomic tur­moil such as the reces­sion in 1985 and the Asian Finan­cial Cri­sis in 1997. Yet STI is still able to rise through­out these years. Since the STI ETF tracks the STI, it is likely that the STI ETF is able gen­er­ate pos­i­tive returns in the long run.

A study was done by La papil­lion, an investor who blogs at bullythebear.blogspot.com. His analy­sis can be found here. The key find­ings from his analy­sis is that on aver­age, STI will give a returns of around 7% in the long run and that excludes div­i­dends. If one includes div­i­dends, the returns is likely to be slightly higher. This return of around 7% is more than the Sin­ga­pore Gov­ern­ment Bonds, which only offer around 4% for long term bonds and def­i­nitely more than the inter­est rate being offered in the CPF accounts.

STI ETF also gives out div­i­dends. Cur­rently it dis­trib­ute div­i­dends twice in Jan­u­ary and July every year.

Click HERE for the STI for the CAGR (com­pounded annual growth rate) of STI.

Defined by Investo­pe­dia as “The year-over-year growth rate of an invest­ment over a spec­i­fied period of time.”

Although I do not receive any com­mis­sions for help­ing my clients invest in the STI ETF , I will still give them advice on how to go about doing it and add it in his per­sonal finan­cial report , which will be reviewed every year.

There is a risk that peo­ple who invest in the STI ETF do not nor­mally con­sider. This is the polit­i­cal risk. That is, the effi­cient Sin­ga­pore could not longer be the the eco­nomic machine it used to be, gov­ern­ments might change, many other fac­tors (e.g. col­lapse of US cur­rency ) that could affect Sin­ga­pore. Any one fac­tor could neg­a­tively impact Singapore’s econ­omy to a large extent and do a great deal of dam­age which we could pos­si­bly not recover from. Sup­pose Mr Tan invest $100k into STI ETF, STI drops from 3000 points to 2000 points due to decreased investor con­fi­dence and regional insta­bil­ity own­ing to a change of polit­i­cal party in Sin­ga­pore (You never know what might hap­pen in 20–30 years time), he stands to lose up to 33.3% of his invest­ment and this could pos­si­bly not be recouped because he needs at least a 50% gain in his cur­rent 66.6k to make back the orig­i­nal invest­ment amount. One might say you are in this for the long term, how­ever, it takes an incred­i­ble amount of TIME to make back your investment.

Hence, Tim­ing is of the essence. BELOW IS AN EXAMPLE.

CLICK HERE TO VIEW THE GRAPH.

Cour­tesy of MoneyTalk.sg

If you had bought the STI ETF on Novem­ber 1999 at a level where the STI is around 2200 points, how long would it take to achieve a pos­i­tive return ? In the pic­ture below I have high­lighted the period for which one bought the STI ETF on Novem­ber 1999 with a green circle.

The answer to the pre­vi­ous ques­tion is 5 years and 3 months ! I have high­lighted the period which the STI approaches the level of 2200 with a red cir­cle. If you had bought near the peak of the STI, it will take you a very long time just to achieve a pos­i­tive return. More­over, if you had held on to the STI ETF which you had bought on Novem­ber 1999 up to this present moment, you will be sit­ting on a paper loss since the cur­rent level of STI which I high­lighted it with a blue cir­cle is around 1700 and this is lower than your entry point of around 2200. Thus it is impor­tant to decide on when to buy the STI ETF.

Alter­na­tive to those who believe that there is still a pos­si­bil­ity to beat the mar­ket index in Singapore

There is also another alter­na­tive for peo­ple with shorter term invest­ment peri­ods who can­not afford a pas­sive strat­egy for long peri­ods of time such as 20/30 years. The alter­na­tive is to invest your funds into a wrap account (sin­gle facil­ity to have unlim­ited free switch­ing amongst the 600+ funds in Singapore).

While one may argue that there is a 1% annual fee (which to some investors is too much), if your finan­cial adviser does give you value add by re bal­anc­ing your port­fo­lio at least once in 6 months (Note: Asset Allo­ca­tion accounts to more than 93% of a port­fo­lio return, rather than mar­ket tim­ing or choice of funds based on a study by Gary P. Brin­son) to ensure your asset allo­ca­tion is intact as well as giv­ing you a good port­fo­lio con­struc­tion based on an invest­ment team’s rec­om­men­da­tions and your risk pro­file and expec­ta­tions, then I per­son­ally feel that it is alright to ser­vice this 1%. In fact the 1% you ser­vice is after all, earned back because every month the invest­ment divi­sion in IPP will sieve out the best per­form­ing fund in each of its class in each sector.

The client’s funds will be taken out of the rel­e­vant sec­tor which he invested as a part of his port­fo­lio and placed into the next best per­form­ing fund. Thus, to ser­vice this 1% , you are essen­tially putting your money in the best per­form­ing fund in each sector.

I help my clients bal­ance their port­fo­lio once every 6 months should they invest in a wrap account.

My Per­sonal Opin­ion. (For For­eign Markets)

For emerg­ing mar­kets such as BRIC ( Brazil Rus­sia India and China) , these future pow­er­houses are in a rapid stage of eco­nomic devel­op­ment. It is pos­si­ble to gain mar­ket beat­ing returns of 10–12 % per­cent con­sis­tently only IF you invest in the right instru­ments. The strong form EMH the­ory does not hold well in such a envi­ron­ment and thus fund man­ager are by and large expected to  beat the mar­ket return. The ques­tion here is whether they will do it con­sis­tently and by how much.

It is impor­tant to find your invest­ment strat­egy because once you decided on it, you must stick to it through thick and thin. (Your invest­ments are a reflec­tion of your own inner beliefs and convictions.)

Tags: active investment strategy, efficient market hypothesis, emh, passive investment strategy, retirement, retirement savings, unit investment trust, unit trust fund