Does it matter whether markets are efficient or not?
Not really and here’s why:
- As I mentioned last week, nobody knows how efficient or inefficient markets are (due to the joint hypothesis problem, eloquently summarized here)
- Asking whether a market is efficient is often a proxy for asking whether one can outperform. However, the questions are different, as we’ll see below.
Last week’s post mentioned Eugene Fama, who won a Nobel prize for developing the Efficient Markets Hypothesis (EMH). However, Jack Bogle (who founded Vanguard) also has a hypothesis called the Costs Matter Hypothesis (CMH), which he introduced here in 2003. Consider the following, which both Fama and Bogle agree on:
- In any market, aggregate investor performance will equal the overall market performance minus costs. This statement holds whether a market is efficient or inefficient. Regardless of a market’s efficiency, investors as a whole will underperform because they bear costs. To outperform the market, you must beat the market by more than your costs.
- Since total investor performance is limited to market performance minus costs, any investor’s outperformance comes from another investor’s underperformance. So to beat the market, you must also beat other participants.
Thus, the important question for investors is not whether markets are efficient or not, but whether they can reliably and consistently beat both the market and other investors net-of-fees. If the answer is yes, investors might benefit from using active management. If the answer is no, it is likely better to use a lower-cost vehicle, such as an index fund.
Of course, there is more than one market. There are many asset classes and markets, so the question of whether you can beat the market or not must be asked over and over. Each market is unique and changes throughout different environments, so the question needs to be continually asked: is it possible for me to beat this market net-of-costs?