Market efficiency: Fees and security
The term "market efficiency," as it is generally used, typically refers to the informational efficiency of markets. A market exhibits informational efficiency when new information is quickly and precisely reflected in the prices of securities. For example, suppose a company makes an announcement that it has surpassed earnings expectations for the most recent quarter, and it expects that earnings in future quarters will also be higher than previously expected. Market participants would most likely perceive this as good news for the company, and in an informational efficient market, the stock price would most likely instantaneously increase by precisely the correct amount in response to this announcement. As such, once the information is released, it is too late for an investor to use the information to their advantage.
The modern notion of an informational efficient market was first proposed in the early 1960s by Eugene Fama of the University of Chicago, giving rise to what became formally known as the Efficient Markets Hypothesis (EMH). The principles of the EMH suggest that it is virtually impossible for any investor to consistently achieve higher risk-adjusted returns than the overall market over multiple periods of time, because at any given time, security prices are believed to reflect all available information. This is not to say that in a specific time period some investors will not outperform the overall market, only that it is extremely difficult to consistently replicate this superior performance.
If the EMH is valid, what is the implication for investors? In short, the biggest implication is that an investor should not expend resources trying to outperform the market, but should instead strive to invest in a diversified market portfolio as inexpensively as possible. Under the assumption that the EMH is true, let's look at a comparative example. Suppose we have two investors: Active Allen and Passive Pete, each who expects to invest $10,000 annually at the end of each year for the next 40 years.
Active Allen expends considerable effort researching stocks, and is constantly trading securities in his portfolio. On average, he spends roughly 2.0percent of his portfolio value in trading and investment management costs. Passive Pete, on the other hand, takes a buy-and-hold strategy and invests all of his money in a passively managed index mutual fund that charges a minimal management fee of 0.25% of his portfolio value. Let's say that the overall return on the stock market averages 10 percent and this is the average return that both Active Allen and Passive Pete experience, before fees, over this 40-year period (remember, if the EMH is true, Active Allen is incapable of beating the market). How much more does Pete have at the end of the 40 year period?
The answer is quite shocking: Active Allen would have a portfolio value of approximately $2.59 million, while Passive Pete's portfolio would be worth approximately $4.14 million. Thus, the seemingly small difference in fees of 1.75 percent over the 40 year period created a difference of over $1.5 million between the two portfolios! The moral of the story is this – unless you (or your investment adviser) has the power to see into the future, in an informational efficient market, fees often matter much more than the choice of specific securities.
The EMH has been intensely studied and debated by both academics and practitioners in the field of finance over the last 50 plus years. It was not until the mid-1980s that a serious challenge to the EMH was brought forth, namely in the form of what became known as behavioral finance. In my next column, I will discuss some of the main points of behavioral finance, and the implications for investors.
Jeff Jones, Ph.D., assistant professor of finance at Missouri State University, is a Chartered Financial Analyst, Certified Public Accountant, Certified Management Accountant and Certified in Financial Management. Views expressed in this article reflect those of the author, have been distributed for educational and informational purposes only, and should not be construed as investment advice or a recommendation of any specific security, strategy, or investment product.Email: jeffsjones@missouristate.edu.