Monday, September 16, 1996
The Modified Efficient Markets Theory
by MF Cormend

One of the basic cornerstones of Foolish investing, probably THE cornerstone of Foolish investing, is the belief that the Efficient Markets Theory is hogwash. For the uninitiated, here's how the Fools describe the Efficient Markets Theory (EMT) in The Motley Fool Investment Guide (page 62):

"[T]he stock market is an efficient thing, wherein all present prices properly reflect the underlying, fair-market value of stocks. What the heck does that mean? Stocks, EMT theorists tell us, are always fairly priced; the only thing that bumps them up or knocks them down are unforeseeable events -- mergers, new partnerships, announcements of new products or services, and so on. Because these price stimulants are "unforeseeable," the Wise tell us, all future movements on the stock market are random, unpredictable. Investing is guesswork. You can't consistently beat the market; it's impossible."

Obviously if the Gardners believed this theory they would not have gone on to write over 200 more pages. You and I would be cozily ensconced in the Vanguard Index 500 Fund and a few trees would be happier.

This August's Smart Money magazine featured a segment about Michael Kinsley, the former Crossfire commentator and journalist who has recently left Crossfire to start Slate, Microsoft's fledgling on-line magazine. One quotation from that piece caught my eye. It arose in response to a question as to why he pays Fidelity to manage some of his money. Says Kinsley, "I believe in a modified version of the efficient markets thesis. Markets may not be perfectly efficient, but they're more efficient than I am. Rationally, there's no insight about the market I can have that the market is not going to already have capitalized."

Is there any validity to this Modified Efficient Markets Theory? I believe there is.

The vast majority of current investors include those either truly ignorant of the tenets of Foolish investing or those who have the knowledge, but are either not willing or able to carry it out in practice. This category includes, but is not limited to, the average investor in mutual funds as well as many mutual fund managers themselves. For those who simply don't have the time, inclination, or proper motivation to devote to effective stock picking, attempts to out-perform the market would seem fruitless at best and disastrous at worst. Does that hot stock tip heard at the office cocktail party really give you that edge over all the other investors out there who are buying and selling? Very unlikely.

The Modified Efficient Markets Theory is especially valid when considering the largest, most highly capitalized stocks, those companies in which more is known by more people than just about any other. Rarely a day goes by in the Beating the Dow (BTD) Message Board where one doesn't see a post such as this recent one:

<<On tuesday I rolled my BTD and picked up GM..... I see that by friday GM dropped to #1 and MRK is back in. Would you recommend a quick correction to switch from GM to MRK? GM seems to be having alot of trouble these days....>>

It really is no trade secret that General Motors is currently having problems with unions and difficulty updating its aging product line. My goldfish, Strawberry, and my six-year-old daughter, Emily, might be two of the few creatures on my block that are unaware of these issues.

The Modified Efficient Markets Theory would say yes, probably 95% of all investors would not be able to ascertain if GM is overvalued or will outperform the S&P 500 over the course of a year. It's those remaining 5% of us Fools that will point to Beating the Dow's more than six decades' worth of proven out-performance to say that, although no one can be certain, GM appears to be undervalued. The chances are certainly high that this auto behemoth will pull itself up by its bootstraps and do its share to get my daughter through college one day.

For those not fortunate enough to apply Foolish principles, the Modified Efficient Markets Theory suggests that indeed these investors might be best off in an index fund. The truly Foolish can agree on the validity of the theory, but also have the luxury of ignoring it.

Transmitted: 9/16/96