Semantron 23 Summer 2023

Value investing versus the efficient market hypothesis

buy stocks at prices low enough, compared to their intrinsic value, to have space for mistakes. 7 For example, Graham suggested purchasing equities at least at two-thirds of their intrinsic value. This limited potential losses if estimations were inaccurate and maximized returns, as the price of the assets would have to grow by half to just meet fair value. 8 In addition, value investors attempt to overcome behavioural biases by making prudent and patient long-term investing decisions. This is because a value investor must wait until the equities he wishes to purchase are sufficiently cheap to give the margin of safety. Thus, value investors frequently act in opposition to most retail investors. For instance, they sell when stocks rise in value and become overpriced or buy when there is a market panic so that assets are attractively discounted. In contrast, according to the efficient market hypothesis (EMH), financial markets are efficient and share prices are fairly valued since they reflect all available information. 9 Thus, equities cannot be undervalued or overvalued, and long-term outperformance of the market is impossible. Since market movements are mostly random, EMH proponents promote investments in passive portfolios with low management fees. Therefore, EMH suggests that individual investors abandon attempts to beat the market and instead join the benchmark. Regarding risk management, the hypothesis enthusiastically adopts the concept of diversification when a portfolio consists of various stocks and asset classes that are exposed to different risks. This enables investors to reduce the risk associated with the failure of a single company, as it would represent a small portion of their portfolio and other assets may compensate for the loss. The main disagreement between value investing and EMH is whether markets are efficient or not, as efficient markets cannot allow for under-priced stocks. Typically, this debate is separated into two questions. 10 First, do market prices correctly represent all the available information? Second, is it possible to outperform the market? Addressing the first part, EMH argues that information can now be transmitted almost instantly to all market players. Consequently, stocks are always valued fairly since all the information is included in the valuation. 11 For example, if there is data that suggests a looming recession, investors will account for this risk (e.g., by selling stocks) and lower the securities price accordingly so that they are not overpriced. However, there are also arguments against market efficiency. First, even if we have a supposedly efficient market, it is challenging to objectively calculate a fair price, mainly because investors use different evaluating techniques. 12 For instance, value investors determine the intrinsic value, whereas momentum traders seek trend opportunities of fast growth. Thus, for example, if short-term shortages of materials may affect a stock, value investors would be eager to buy it since the business model is not affected, in contrast 7 Graham 1965: 560. 8 Scott, G. Margin of Safety . 9 Scott, G. Efficient Market Hypothesis (EMH). 10 Fama, E.; Thaler, R. Are markets efficient? 11 Baldridge, R. What Is the Efficient Market Hypothesis? hypothesis/.

12 Potters, C. Efficient Market Hypothesis: Is the Stock Market Efficient?


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