MARKET EFFICIENCY: Diversification remains the best bet by Ron Copley, Ph.D, CFA, LOL contributing writer
Irma caused incredible devastation, but it also presented an excellent opportunity to discuss the most important factor driving stock prices: the speed in which information is reflected in current valuations. Financial theorists have long discussed the matter called “Efficient Market Hypothesis.” The efficient view is stock prices immediately reflect full information. The inefficient view is the market is slow in absorbing information.
While no clear or correct answer exists, theorists are generally divided into two camps: The academic world believes the market is efficient, while Wall Street considers it inefficient. If efficient, investors should employ a broad-based diversification strategy. If inefficient, they should follow a stock-picking strategy.
Damaged homes and buildings require repair. Companies like Home Depot (HD) that supply needed building materials would seem a sure bet for investors seeking an abnormally high return due to rebuilding costs running as high as $100 billion. Before jumping to such conclusions, we must consider the efficiency question.
The following analysis addresses how efficiently the market priced HD after the storm. Compare HD’s actual return to what was expected. When making such a comparison, the returns should be adjusted for risk. Beta provides that measure. A beta of 1.0 shows the stock has risk equal to that of the market, as measured by the S&P 500. A beta greater than 1.0 shows greater risk, while a beta less than 1.0 shows less risk. HD’s beta of 1.06 is not significantly greater than 1.0, so its risk is generally in line with that of the S&P 500, and the two returns should be approximately equal.
Irma hit Florida on August 28. Three weeks later, HD had increased 7.6 percent while the S&P 500 had increased only 2.5 percent. Stock-picking investors who purchased HD stock August 29 experienced a nice short-term gain. This anecdotal evidence follows inefficiency theory since HD’s actual return far exceeded its expected return for such a short period.
A few words of caution are in order. A stock-picking strategy requires taking high risk. Academic studies called “event analysis” have studied the strategy using many events, such as storm devastation, over many time periods. While some events show market inefficiency, the clear majority does not. This academic evidence supports the efficiency theory.
The problem with event analysis is the news is continuous. News of profit potential coming from a storm can be offset by other news coming from a different direction. Trying to untangle continuously arriving news can be nerve-racking! Recent news coming out of North Korea, combined with the Fed’s announcement of reducing the size of its balance sheet, is just one example of news driving stock prices in presumably different directions. Stock-picking is tough business!
Another issue is Wall Street has a vested interest in promoting the inefficiency idea. An inefficient market encourages investors to trade—and the more they trade, the more revenue brokerage firms receive. If the market is inefficient, finding mispriced stocks would be easy, and we would all be rich. This makes no sense.
For thrill-seeking investors who enjoy taking high risk, a stock-picking strategy requires spending a lot of time and money on research. A practical question is how to reduce thousands of stocks down to a few for intense analysis. Professional analysts use filters. Once the universe has been reduced to a manageable few, the analyst then studies the remaining stocks. Some analysts succeed and others do not, but the data are clear that successful analysts in one year are unlikely to succeed in following years. Continuous success year after year is highly unusual, even for professional analysts much less amateur investors.
Having analyzed stocks for almost 40 years, I can state finding inefficiently priced stocks is very difficult. I tell my students they would be lucky to select poorly performing stocks as their first experience because if they by chance select good performers, they may consider themselves talented. Such a conclusion would most likely result from luck.
A better strategy is diversification across multiple asset classes and within each asset class. A diversification strategy may not be as exciting as stock-picking, but it is certainly more appropriate for a retirement account. If someone enjoys the thrill of picking stocks, I recommend doing it in a non-retirement account where losses won’t affect lifestyle. LOL
Ron Copley is principal of Copley Investment Management, a Registered Investment Adviser in Wilmington. Besides managing money for individuals, retirement plans, and foundations, he conducts business valuations for the legal community and teaches part-time at UNCW.