Carnival of Investing #60 is up at FIRE Finance and features AFR’s article on the Efficient Market Hypothesis.


Carnival of Personal Finance #87
is up at My Journey to Financial Freedom and includes a little primer on building a credit history.

The Festival of Frugality #61 is up at Hustler Money Blog and features the ATM at the Edge of the Universe.

Popularity: 12%

Who: This post is for people who have heard that it is best to invest in Index Funds. If you are skeptical about this claim, or just want to hear both sides of the story, this post is for you.
What: This post will discuss the reason for the “common wisdom” that Index Funds are the best way to invest for the long term. Some drawbacks about Index Funds will be mentioned as well as some assumptions which, if true, mean that index funds are not the best investment option.



Caveat: I had a feeling that I may draw some heat for this post, so I want to make sure my position is known. I like index funds. I think that they serve a specific purpose and are a solid investment choice for many people. However, I do think that many writers unjustly tout the benefits of index funds without explaining the assumptions that need to be true in order to make index funds the best option. So, this post is not saying that index funds are bad (they’re not) and it is not saying that they are the best thing since sliced bread (they’re not). It is recommended that you read the first part of the series about The Good of Index Funds.

Index Funds Sound Great! What’s the Catch?

Index Funds don’t beat the market. This one is simple enough… since index funds are meant to track a market, they obviously won’t beat the market on a consistent basis. In fact, on average index funds will *slightly* underperform the market because the expense ratio (granted they’re small on most index funds) erodes returns.

If you do not agree with the Efficient Market Hypothesis, then Index Funds may not be the best investment option for you. If you believe that it is possible to beat the market on a consistent basis with sound technical or fundamental analysis, then you would be better off trying to either beat the market yourself, or find money managers that can do it.

Finding someone that can consistently beat the market is not easy. If you think that it is possible for fund managers to beat the market over the long term, that does not necessarily mean that YOU can correctly identify those managers. If you think you can identify those managers, index funds are NOT your best investment option.

Conclusion

Ultimately, I hope that you do not blindly follow the “index funds are best” advice. I hope that everyone can make their own informed decision on whether or not they think index funds are best for them. That being said, I must recommend index funds to MOST investors. The only time I would not recommend index funds to investors would be if 1) they do not believe in the strong or semi-strong form of the EMH AND IF 2) they can consistently pick fund managers that can beat the market (or beat the market themselves). Keep in mind that many investors may think #2 is true about themselves when it is really not :-)

Final Verdict: B+
Note: This verdict reflects a highly complex algorithm which determines how awesome a financial product is. This is not limited to investment products.

Popularity: 13%

Who: This post is for people who want to know why many people advocate index funds as an investment choice. If you’re familiar with index funds already, this post probably won’t tell you much more than you already know, but it is a good segue into the 2nd part of this series.
What: This is the first in a set of 2 posts about index funds. This first post will highlight the good and the 2nd post will talk about the caveats and some drawbacks to index funds.



Index Funds are Cheap. A mistake that many intermediate investors make is to use their newfound investing knowledge too much. Some investors trade very frequently, acting on all of their hunches and ideas, buying and selling at the drop of a hat and piling up commissions and fee-loaded funds. Commissions and fees erode returns and most index funds have very low fees. Naturally, this makes them a solid pick.

Index Funds are tax efficient. Without going into details about income taxes, I will describe what this means. When funds buy and sell securities, the profit that they make is required by law to be passed onto its customers in the form of a distribution. This distribution is commonly referred to as a capital gains distribution. When distributions are received, they are taxed at your income bracket (if they are short term capital gains). Funds with higher turnover (more buying and selling) will have higher taxable distributions and funds with lower turnover will have lower distributions, which means you pay less taxes.

Index Funds Give Instant Diversification. Hopefully, this one does need much explanation. When you purchase an index fund, you are purchasing a basket of securities which diversifies you. Diversification is one of the best deals on this planet.

Popularity: 13%

Who: This post is for people who want to know more about the Efficient Market Hypothesis, what it means, and how it can be applied to investment decisions.
What: This post will discuss the Efficient Market Hypothesis with some simple examples and some more complex explanations at the end. The three forms of the hypothesis (weak-form, semi-strong form, and strong-form efficiency) will all be discussed in this post.



What is the Efficient Market Hypothesis? (EMH)

The EMH makes the claim that the prices of assets/securities in financial markets reflect all known public information. In other words, the price of assets in financial markets are determined by the collective outlook of the market participants based on all public knowledge. This implies that any public information about a security has already been taken into account to determine its current price. Simply put, prices in the market are “efficient” and at any given time the price of a security is fair, based on publicly available information.

So, What’s the Big Deal?

-If we assume that the EMH is true, then no one can consistently beat the market by using any sort of “skill.” Any outperformance of the market (with commensurate risk) will be by pure luck.

-In an efficient market, information or analysis that is done to indicate that a stock is a “buy” is not helpful because the outcome of that analysis should already be included in the stock price of the security.

-Any news about changes to a company affect its stock price almost immediately in an efficient market. If the price did not change in response to the news (and it is something that SHOULD have changed the stock price), then there is a point in time which this information is known, and the price does NOT reflect that information. If the EMH is true, this cannot occur.

Three Forms of the EMH

Weak-Form - This is the form of the EMH that is believed by most value investors. The main characteristics are that 1) technical analysis (moving average analysis, price point analysis, etc) will not produce consistent, market-beating returns, 2) one cannot generate returns that beat the market by using analysis and strategies based on historic financial data and 3) insightful fundamental analysis MAY be able to identify undervalued and overvalued stocks and generate market-beating returns.

This is my interpretation of choice because I believe that those with good insights about the future of an industry/company/asset class and those who inquisitively examine financial statements can use publicly available data to make educated guesses about a company’s value that may be BETTER than the market’s guesses as a whole.

Semi-Strong Form - The semi-strong EMH is different from the weak-form in that it implies that fundamental analysis will be unable to consistently produce market-beating returns. The semi-strong version of the EMH states that the introduction of new information into a market will affect stock prices almost immediately, thus making it impossible to gain excess returns by trading on the “new” information. In other words, stock prices quickly react to new public information and as such it is not possible to beat the market consistently.

Strong-Form - This is the exact same as the semi-strong form with one key exception. The strong form of the EMH states that a security’s price reflects ALL information about a company, not JUST public information. In other words, all public and insider information about a company is reflected by the stock price. This is very difficult to justify because of laws prohibiting the public availability of private information.

Conclusions and Questions to Ask Yourself

Do you believe the EMH? If so, which form? Do you think asset managers can consistently beat the market? If you agree with the EMH, then it would seem that index funds would be the best investments, right? (I will be covering this topic very soon). If you do not agree with the EMH (which many people do not), then are index funds REALLY the best choice?

If you’d like to read more about the Efficient Market Hypothesis, here are some cites to my favorite academic papers and a link to one of the best EMH books out there:

The one that started it all:
Fama, E. [1970] “Efficient capital markets: A review of theory and empirical work,” Journal of Finance 25, 383-417.

Efficiency Speed
Gosnell, T., A. Keown and J. Pinkerton [1996] “The intraday speed of stock price adjustment to major dividend changes: Bid-ask bounce and order flow imbalances,” Journal of Banking and Finance 20, 247-266.

Patell, J. and M. Wolfson [1984] “The intraday speed of adjustment of stock prices to earnings and dividend announcements,” Journal of Financial Economics 13, 223-252.

Popularity: 18%

If you have not heard already, PayPal is offering it’s members a $15 rebate for a purchase of $30 or more from eBay or a merchant that accepts PayPal, provided you pay with PayPal. I have highlighted SOME of the caveats, but make sure you read the fine print.

1. You must register the PRIMARY e-mail address on your PayPal account here: Register Your Address

2. You must make a single purchase of $30 or more at an eligible merchant to qualify. Eligible websites include:

“You must make a purchase on www.eBay.com, www.eBay.ca or any United States or Canadian website that accepts PayPal. Purchases on www.eBay.com and www.eBay.ca must be made through the eBay checkout flow via the eBay website and must not be made through the PayPal Send Money tab.”

3. The promotion period begins on February 8, 2007 at 12:01 AM PST and ends on March 31, 2007 at 11:59 PM PST.

4. Some transactions are excluded:

“The following transactions are excluded from this offer: Send Money transactions, payments to Personal Accounts, eBay payments made to Personal Accounts, donations, PayPal Mobile transactions, payments for services, Virtual Debit Card payments, PayPal ATM/ Debit Card payments and PayPal Plus Credit Card payments not made through your PayPal account.”

5. Your rebate will be deposited into your PayPal account by May 28, 2007.

6. There is a limit of one discount per PayPal account and the account must be in good standing.

Popularity: 9%

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