Information Velocity & The Efficient Market Hypothesis
A Division of GreatBanc Trust Company
In 1906, a gentleman named Francis Galton attended a farmer's fair and observed a contest guessing the weight of an ox. More than 800 guesses were registered, including both regular townspeople and livestock experts.
Amazingly, the collective average guess was only one pound less than the actual weight of 1,198 pounds and much closer than any of the livestock experts. He referred to this phenomenon as "The Wisdom of Crowds".
Following along the same line of thought, Nobel laureate Eugene Fama developed the Efficient Market Hypothesis (EMH). EMH states that it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. Both academic theory and actual experience show this theory to be true in the large cap domestic equity markets.
However, historically the Efficient Market Hypothesis has not held true in in small cap and foreign markets. The information flow to the market has been less than perfect, leading to pricing that does not accurately reflect the value of these companies. Even twenty years ago, dedicated teams of multilingual analysts could pick through overlooked stocks in emerging markets to gain a sustainable edge over the local markets.
If information is the key to security prices, how has the vast improvement in information distribution, largely driven by the internet, affected the efficiency of securities prices? More importantly, how can you use these changes to your advantage?
The improvements in information flow has allowed for much better price discovery in these formerly inefficient markets. This means those markets are becoming more efficient as well, and again the advantage of trading in and out of these individual stocks has been truncated.
By using baskets of these securities, and eschewing the additional costs of active management, we have cut the cost of investing across these markets. In some cases, your cost of investing will be 1/20th of a traditional active manager.
Instead of actively managing individual positions, we have focused out attention on allocating properly and opportunistically across an ever expanding range of asset classes. By using the “Wisdom of Crowds”, we have improved the efficiency of our portfolios, which at the end of the day, means you pay less and keep more.
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