FOOL ON THE HILL
Beating an Efficient Market

Efficient Market Theory says it's difficult or impossible to beat the market over the long run. Many others, Warren Buffett included, think the opposite. Being serious, diligent, and becoming an expert on a few companies and industries will give you a fighting chance.

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By Rex Moore (TMF Orangeblood)
January 17, 2003

Do individual investors have a reasonable chance of beating the market?

It's an issue that will never be settled to everyone's satisfaction, so I don't even know why I'm trying to tackle it. They warned me not to, saying I'd just receive a bunch of angry emails from both sides. But I have little to lose because I'll likely never see the emails anyway, lost as they'll be among "URGENT ASSISTANCE NEEDED," "Eliminate Your Tax's Legally!!!," "Improve your love life!," and "I'ma make you look so ridiculous now!" (That last one was from my editor).

So, here goes: I believe individual investors can beat the market averages. Certainly not everyone, but those who put their minds to it have a reasonable chance.

Now, this isn't exactly big news. We've been saying it for years at The Motley Fool. But some very compelling arguments counter our belief.

The most famous comes from Burton Malkiel, author of A Random Walk Down Wall Street. This is such a good read that I recommend it without hesitation, even though I disagree with his basic premise that it's difficult or impossible to beat the market over the long run.

Or how about Princeton professor Daniel Kahneman? When asked about individual investors beating the market, he said simply, "They're just not going to do it. It's just not going to happen." Kahneman may have some idea what he's talking about; he's a Nobel Prize winner in economics.

Generally speaking, these people subscribe to the Efficient Market Theory, otherwise known as EMT. The theory has many forms, and there are different interpretations of each form, but in a nutshell, EMT proponents believe:

  • There is no way to consistently predict future price movements from past results.

  • All relevant information about a company is already reflected in its stock price, and the price reacts to any new information by adjusting quickly.

  • Because prices are so efficient, a blind orangutan throwing darts at a list of stocks has just as good a chance of beating the market as someone who puts hours of work into the process. (Malkiel uses "blindfolded monkey" in his book, but I like my example better.)

Reams have been written about this subject (there's a great recent discussion about EMT on our Berkshire Hathaway (NYSE: BRK.A) board, in fact.) Experienced investors likely made up their minds long ago, and I'm not attempting to change them. This reminds me of how there's an opposite and equally impassioned argument for each side of nearly any political issue. Dozens of experts can line up and tell you why affirmative action, for example, is a bad thing, and dozens can line up and tell you why it's a good thing.

But I'm not here to change anyone's mind. I just want to put forth a few points for those who want to beat the market, and hope those who are interested will seek out more information.

Be serious and diligent
Making the leap from index funds to individual stocks is not something to be taken lightly. It requires a lot of effort. If you don't want to spend several hours going over numbers, reading reports, discussing the company on our boards, etc., then you shouldn't even think about it.

For some, this would be pure drudgery. However, for many, this is a very stimulating and enjoyable process. There is a great satisfaction that comes from learning and growing and stretching the mind... even more so when the effort goes toward bettering your financial standing.

Become an expert on a few companies/industries
One of the keys to being a successful investor is not stretching yourself too thin. I think it's better to start slowly, learning all you can about a company you're interested in. (And if you need stock ideas, consider The Motley Fool Select and Motley Fool Stock Advisor.)

If you decide not to invest in it, that's fine. You've gained some valuable knowledge. If you do invest, perhaps start off with just a few shares. (There's no one right answer for what percentage of your portfolio a single stock should comprise, but smaller is more conservative.)

After that research, start again with another company and repeat. This process will guard against building a portfolio of many companies that you know little about, which is a dangerous thing. Instead, you'll own a few companies you know a lot about.

It's like the board game Risk, where you can place small armies on many countries, or larger armies on fewer countries. The small armies, stretched far and wide, are more likely to be wiped out. The larger armies are more likely to hold their ground, and expand beyond their borders.

OK, I can't believe I just made that comparison either. Regardless, owning a few companies you know a lot about, along with having a decent percentage of your portfolio in an index fund (read about "index plus a few" here), is an ideal allocation, in my opinion.

In conclusion
I firmly believe that people who enjoy learning and who are able to apply this slow, disciplined approach stand a reasonable chance of beating the market averages. It's not easy, but it can be fun and rewarding.

And the best part is this: Even if you don't have the time and inclination for all this research, or even if you believe in the Efficient Market Theory, index funds are ready and waiting for you, virtually guaranteeing market-matching performance with little effort on your part.

Rex Moore asks you to hold your applause until all contestants have been introduced. At time of publication, he owned shares of Berkshire Hathaway. The Fool has a disclosure policy.