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Question #78989 posted on 09/05/2014 11:30 a.m.
Q:

Dear 100 Hour Board,

How much would you agree with the following sentiment?

Given the immense number of factors influencing the dynamics of a stock's price and the speed and complexity at which those factors interact, an individual trying to pick an individual stock that he or she thinks will rise based on the amount of reading from the number of sources a normal human can do and the speed at which a normal human can take it in and process it is like trying to predict the flow out of a fire hydrant based on a teaspoon sample.

-It's Luck

A:

Dear Luck,

The issue revolves around the efficient-market hypothesis. Taking this straight from Wikipedia, "in finance, the efficient-market hypothesis (EMH) asserts that financial markets are 'informationally efficient'. In consequence of this, one cannot consistently achieve returns in excess of average market returns... given the information available at the time the investment is made." 

Under stronger versions of the EMH, the price of any asset is instantly priced according to all available information. In other words, as soon as any news is released publicly, the market instantly reacts to the results and re-prices the assets. This means that a single person would probably be unable to (1) comprehend and utilize as much information as the market as a whole, or (2) react fast enough to news to realize gains. This is similar to the situation that you described with the fire hydrant: a single actor is unlikely to predict market trends (and therefore unable to 'achieve returns in excess of average market returns') unless they are one of the smartest market analysts in the world and can make sense of all the information, have insider information, or are incredibly lucky.

The reality is, the EMH is not totally true. There are many situations where it breaks down. EMH is still a good representation of market behavior as a whole, but the truth is that the strongest forms do not hold up in many situations and even the weaker forms are not always accurate. There is still plenty of debate and research in the academic world about how realistically the EMH describes market behaviors.

Because the EMH may break down in some situations, there are definitely times when informed and skilled investors can make returns not because of luck, but because they made accurate predictions. I think these situations are less common and I personally tend to believe that the EMH is fairly strong. I don't believe that most individuals can consistently perform much better than the market average. But it does happen and I'm not convinced that it's all attributable to luck. Others may take different opinions on this because the EMH is only a hypothesis, but I think many would agree that it is possible, but very challenging, to make returns higher than the market average.

-Ozymandias