Beware bad financial journalism

(MoneyWatch) I'm always amazed by what is passed off as financial journalism. The good news is that bad journalism provides me with a never-ending supply of material for my column. The latest bit of foolishness to catch my attention was the Motley Fool column "Does Efficient Market Hypothesis Hold Water?" The author's opinion is that it doesn't. However, the problem isn't with the conclusion that the market isn't perfectly efficient. The problem is with the author's analysis.

There are many anomalies that the efficient market hypothesis can't explain, such as the momentum premium and the poor performance of small growth stocks, IPOs, penny stocks and stocks in bankruptcy. Many also consider the value premium to be an anomaly as well. Yet the analysis used by the author leaves something to be desired. Let's critique two specific bits of evidence offered up by the author.

Tulips and bubbles

The author writes, "There have been a number of bubbles in the stock market's history. The first recorded bubble was Tulip mania, which happened in 1637. More recent ones would be the dot-com bubble in 2000 and the housing bubble in 2007. Bubbles happen when the price of an underlying asset rises too much from the fundamentals of the asset."

It's always easy to identify a bubble after the fact. However, active investors have had a very hard time identifying them while they are occurring. If they had such skills, active managers would outperform when bubbles burst. In other words, the relevant question for investors isn't, "are markets efficient?" Rather, it's, "Are active investors able to persistently exploit anomalies (mispricings) after all costs?"

According to S&P Indices Versus Active Funds Scorecards, the answer is no. In fact, we see that in the scorecard published right after the most recent bubble, when Standard & Poor's said, "The belief that bear markets favor active management is a myth." This is why renowned investor Charles Ellis called active investing a "loser's game." It's not that you can't win, but rather that the odds of doing so are so poor that it's not prudent to try.

Warren Buffett's record

The second bit of evidence offered in the column as proof that the efficient market hypothesis doesn't hold is Warren Buffett's track record.

While it's true Buffett has had a spectacular career, that record doesn't provide any evidence that the market is inefficient. Given the number of investors trying to beat the market, randomly we would expect some to do so by wide margins and even over long periods. That's what studies on the subject have found: There are some winners, but there's actually less persistence than would be randomly expected. Thus it's very difficult to separate skill from luck.

The author did offer one important takeaway: "Warren Buffett would have not been successful in the stock market if EMH was entirely true. He quipped once: 'I'd be a bum on the street with a tin cup if the markets were always efficient.' ''

I don't know what you can take away from this statement in terms of investment strategy, but it's a fun quote from Buffett. If the author was suggesting that you should try to pick stocks or winning fund managers because markets are inefficient, the evidence demonstrates that following that advice makes you highly likely to underperform appropriate risk-adjusted returns.

Bad financial journalism is abundant; it pays to read with a wary eye.

Image courtesy of Flickr user NS Newsflash

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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