a) The market is efficient insofar that it represents the money weighted average of the smart analysts and the stupid analysts. Sometimes even the smart people are stupid. Some smart people saw the tech bubble as soon as 1998. The wise people left. But some went short and got squeezed out as the folly continued for another two years. Also some smart people went stupid. This was repeated with the CDOs of late.
b) Institutional managers are also people. Career wise it is prudent to not veer to far off of the course of the herd. If a manager is right while the market is wrong, he is taking a chance. If the manager is wrong while the market is wrong, he is wrong along with everyone else. Job secured. It is important to note that many analysts and managers depend more on their paycheck and fees than their management skills.
c) Thus creativity (and market beating returns) are found in the smaller outfits you have never heard about.
c) Highly liquid stocks like blue chips are closely followed. However, stocks which trade a daily value of maybe $50,000 are not (a volume of 5,000 at $10 say). These are not worthwhile for institutions to dabble with since institutions need to move millions each day. This is where individuals and smaller outfits can shine picking up $5,000 here and $5,000 there.

So to reiterate a point I made in the comments above. EMH is an MM (statistical) model of an MF (algorithmic) world. It is a model of reality that is demonstratively an approximation. We can show this with simple deductive reasoning. Still for a herd of a few thousand professional money managers that move big currents of money it is a pretty good model.
Thus individual investors should probably stick to the FF part of Wall Street where institutions rarely go. E.g. individuals should play in the pond and not the ocean. Such companies are not followed by analysts, have little institutional ownership, and have large insider ownership. You can minimize downside risk by picking them up at low P/B values. There are a few other things to look for as well. Maybe I’ll do a post on it right after my favorite pan cake recipe

Yeah, but I think individuals should stick to their philosophy for the best results. It’s the trend or philosophy chasers that fail in the long term.

Now that I admit that a window exists for outperforming the market, do I think that there are many people in the world who can pull it off? Probably not, at least for any extended period of time. We might pick up on one or two or even a few exploitable situations but not a whole career of them. Money managers and Wall Street guys are no better or worse than you or I. By definition we will almost all end up near the mean!

That is, unless we are lucky enough to spot a window of opportunity and have the funds available to exploit it (but not too much because that makes it hard to exploit as well). Beating the market is possible but it is hard and still a crap shoot. Try if you want, but I’m not holding my breath on my ability to “break” Wall Street and neither should you.

There’s a bigger problem though. In the world we are essentially dealing with four different systems. Few agents with few degrees of freedom (solar system, most engineering), Many agents with few degrees of freedom (economics, sociology, …), Few agents with many degrees of freedom (biology, group dynamics, …), and Many agents with many degrees of freedom (thermodynamics, statistics).

FF is analytically tractable. MM is statistically tractable. Neither FM or MF can be solved with those methods. They can be computationally treated but the problem is immense.So what people do is that they try to see how much economics diverge from a MM model. That’s the Fama and French study. The hypothesis is not correct, but it is almost correct statistically speaking. I think 90% of the correlation could be explained with the three factor model and somewhat less with a one factor model. Of course if you go into medicine, you are not going to sell any drugs that are only 90% correlated. That would be pretty bad. Medical doctors like to see 95%. Chemists more than 99%. Physicists generally insist on several 9’s e.g. 99.999% in order to say that something is scientifically proven.

One might say that the market actors are rational on average in the long run. But that is true by definition.

@ Ron - Those extended periods are exactly why I’m fearful of index investing (Nikkei 1990-2008 is worse than nowhere). They happen when the large companies in the index are going nowhere while the smaller companies cancel each other out. What is especially bad is when index investing is sold to fund buyers based on projecting 1981-Now returns, around 11%, into the far future. That’s just unethical.

Buffett’s legendary response to claims of these sort was his Superinvestors of Graham-and-Doddsville speech for the 1984 Columbia University commencement:

http://www.tilsonfunds.com/superinvestors.pdf

For those who think index funds are the ONLY way to go, remember that the US market’s index rate of return has been zero or less from 1905-1942, 1965-1983 and from 2000-2007.

Taking another stab at EMH, from another angle, the hypothesis seems to hold the belief that market actors are net rational. My life is full of watching (and sometimes participating in) irrational microeconomic decisions. Humans make enough irrational decisions to undermine anyone’s hope that stock market phenomena can be free of irrationality. What I’m saying is that even if one’s point of departure is that all private and public information is in the hands of the market actors, whether those actors will always act rationally upon that information is dubious.

I love that.

I am not convinced (yet) but it is some food for thought.