Warren Buffett on EMH

I recently came across Warren Buffett’s 1988 letter to shareholders and came across an excellent excerpt on the Efficient Market Hypothesis, which I think everyone who invests in stocks or mutual funds should read and understand.

The EMH says that the markets are efficient as they price in all available information about a stock, and as a result it is not possible to consistently beat the market. I’ve never believed in this theory  and have suffered low grades in finance papers (among other things) as a result of that belief. But the way I’ve always looked at this is the volatility in the price of stocks, and the great difference between the prices that stocks exhibit in any 52 week period.

I’ve excerpted this from The Intelligent Investor before, and I think it explains my point well here as well.

A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price. The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.

The swings are not signs of a rational market.

Now, on to the excerpt from the letter itself. (Emphasis mine)

Efficient Market Theory

The preceding discussion about arbitrage makes a small 
discussion of “efficient market theory” (EMT) also seem relevant.  
This doctrine became highly fashionable - indeed, almost holy 
scripture in academic circles during the 1970s.  Essentially, it 
said that analyzing stocks was useless because all public 
information about them was appropriately reflected in their 
prices.  In other words, the market always knew everything.  As a 
corollary, the professors who taught EMT said that someone 
throwing darts at the stock tables could select a stock portfolio 
having prospects just as good as one selected by the brightest, 
most hard-working security analyst.  Amazingly, EMT was embraced 
not only by academics, but by many investment professionals and 
corporate managers as well.  Observing correctly that the market 
was frequently efficient, they went on to conclude incorrectly 
that it was always efficient.  The difference between these 
propositions is night and day.

     In my opinion, the continuous 63-year arbitrage experience 
of Graham-Newman Corp. Buffett Partnership, and Berkshire 
illustrates just how foolish EMT is. (There’s plenty of other 
evidence, also.) While at Graham-Newman, I made a study of its 
earnings from arbitrage during the entire 1926-1956 lifespan of 
the company.  Unleveraged returns averaged 20% per year.  
Starting in 1956, I applied Ben Graham’s arbitrage principles, 
first at Buffett Partnership and then Berkshire.  Though I’ve not 
made an exact calculation, I have done enough work to know that 
the 1956-1988 returns averaged well over 20%. (Of course, I 
operated in an environment far more favorable than Ben’s; he had 
1929-1932 to contend with.)

     All of the conditions are present that are required for a 
fair test of portfolio performance: (1) the three organizations 
traded hundreds of different securities while building this 63-
year record; (2) the results are not skewed by a few fortunate 
experiences; (3) we did not have to dig for obscure facts or 
develop keen insights about products or managements - we simply 
acted on highly-publicized events; and (4) our arbitrage 
positions were a clearly identified universe - they have not been 
selected by hindsight.

     Over the 63 years, the general market delivered just under a 
10% annual return, including dividends.  That means $1,000 would 
have grown to $405,000 if all income had been reinvested.  A 20% 
rate of return, however, would have produced $97 million.  That 
strikes us as a statistically-significant differential that 
might, conceivably, arouse one’s curiosity.

     Yet proponents of the theory have never seemed interested in 
discordant evidence of this type.  True, they don’t talk quite as 
much about their theory today as they used to.  But no one, to my 
knowledge, has ever said he was wrong, no matter how many 
thousands of students he has sent forth misinstructed.  EMT, 
moreover, continues to be an integral part of the investment 
curriculum at major business schools.  Apparently, a reluctance 
to recant, and thereby to demystify the priesthood, is not 
limited to theologians.

     Naturally the disservice done students and gullible 
investment professionals who have swallowed EMT has been an 
extraordinary service to us and other followers of Graham.  In 
any sort of a contest - financial, mental, or physical - it’s an 
enormous advantage to have opponents who have been taught that 
it’s useless to even try.  From a selfish point of view, 
Grahamites should probably endow chairs to ensure the perpetual 
teaching of EMT.

     All this said, a warning is appropriate.  Arbitrage has 
looked easy recently.  But this is not a form of investing that 
guarantees profits of 20% a year or, for that matter, profits of 
any kind.  As noted, the market is reasonably efficient much of 
the time: For every arbitrage opportunity we seized in that 63-
year period, many more were foregone because they seemed 

     An investor cannot obtain superior profits from stocks by 
simply committing to a specific investment category or style.  He 
can earn them only by carefully evaluating facts and continuously 
exercising discipline.  Investing in arbitrage situations, per 
se, is no better a strategy than selecting a portfolio by 
throwing darts.

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