Understanding Market Efficiency
The Efficient-Market Hypothesis (EMH) states that asset prices reflect all available information immediately.
Howard agrees that asset prices immediately reflect the consensus view of the information available. He does not, however, believe that the consensus view is necessarily correct.
For example, Yahoo shares sold at $237 in January 2000, and in April 2001 it was at $11, the market had to be wrong on at least one of those occasions.
Sharing the consensus view will make you likely to earn just an average return.
Second-level thinkers depend on inefficiency.
Most people are driven by fear, greed, envy, and other emotions that render objectivity impossible and open the door for significant mistakes.
Market inefficiency is a necessary condition for the outperformance of the market but does not guarantee it.
Market prices are often wrong. They are often far above or far below intrinsic values.
Respect for efficiency says that before we embark on a course of action, we should ask some questions:
- Have mistakes in pricings been driven out through investors’ concerted efforts, or do they still exist, and why?
- If the return appears so generous in proportion to the risk, might there be some hidden risk I am overlooking?
- Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
- Do I really know more about the asset than the seller does?