@Patrick – I thought the very definition of an efficient market was that everybody agreed on the value of a stock at all times. Or are we talking about the value of a stock relative to, say, the value of a new toaster? If it is the former, then if it became known that the value was $200 instead of $100, everybody would simply double their bid and asks, from, say 99/101 to 198/202 and no trades would take place. The degree to which trades take place is a measure of the inefficiency of the market.

@Jacob: The efficient market hypothesis supposes that the present market price of an asset reflects all information already known about that asset. It doesn’t suppose that all participants know all information, so the participants are free to disagree, and therefore to continue trading.

Regardless, even if everyone knew and agreed upon the correct value of a share in a company, that does not imply zero returns. Shares pay dividends and companies retain earnings to find growth. Even a perfectly stable (risk-free) company in a perfectly efficient market would grow in value and/or pay dividends over time. Shares in such a company would effectively be a GIC, and should increase in value in step with the time value of money.

Interesting theory on the boomers depressing the markets BTW. You may be on to something there.
However, as someone who will be a net purchaser of stocks for the foreseeable future, I welcome anything (within reason!) that makes them cheaper for me to buy.

I also think that these resulting lower prices will make stocks that much more attractive from the point of view of P/E and earnings yield, possibly attracting more money that’s currently invested in other assets. I wouldn’t mind seeing us return to an era of P/Es in the 10-15 range and dividend yields up around 4%!

Incidentally, check this out: http://www.multpl.com

“Since trading happens, markets are not efficient.”

I think this would only be true if humans were immortal and perfectly consistent in their investment objectives over time. Neither is the case, so in practice there will always be a certain amount of “lateral move” exchanges, even in an efficient market. E.g., a student inherits a stock portfolio and immediately liquidates it to pay for college. That kind of churn does not imply that markets are inefficient.

@Patrick – but if the future dividends were known*, wouldn’t that already be factored into the present value of the stock?

*Known meaning you could assume the current level of dividends going forward plus historical annual increases factored in.

We need to see more people questioning the basic premises of the failed Passive Investing model. So I heartily approve of this thoughtful blog entry.

I do not agree that efficient markets have zero returns.

An efficient market would generate the return justified by the economic realities. For the U.S. market, thats about 6.5 percent real.

If our market were efficient, there would be no volatility. Each year stocks would pay something in the neighborhood of 6.5 percent real.

I think that would be just wonderful. I think we all should be working to make the market efficient rather than developing nonsense rationalizations that convince us that it already is efficient. The reason why the reckless promotion of Passive Investing for three decades now has caused such a frightening economic crisis is that a belief that Passive Investing can work encourages investors not to do what need to be done to make the market efficient (that is, not to change their stock allocations in response to price changes).

The belief in Passive Investing is rooted in a belief that the market is efficient, Paradoxically, the more people believe in Passive Investing, the less efficient the market is. If we could bury the Passive Investing concept 10 feet in the ground, we could have a market far more efficient than the one we today have.

Rob

@Kevin M: By your argument, GICs don’t provide any returns!

Are you familiar with the concept of the time value of money?

@Rob Bennett: “Paradoxically, the more people believe in Passive Investing, the less efficient the market is.”

That is not true. Adding more traders to the marketplace only increases trading volume. That is one aspect of market efficiency, but by no means the only aspect.

Adding more naive traders with self-directed accounts can dilute the overall wisdom of the market, actually hampering efficiency. Suppose, hypothetically, that for every $1 from well-informed investor you have $1000 from gamblers, day traders, and technical analysis, then there’s no reason to think assets should be more fairly priced than if the $1000 went into passive funds and where therefore directed by the decisions of the remaining investors.

I’m not saying this reflects reality. I’m just saying that increasing passive investment doesn’t necessarily reduce market efficiency.

Eliminating volatility doesn’t just require eliminating inefficiency. It also requires eliminating surprises.

We don’t agree re this one, Patrick.

If you look at the historical stock-return data, you will see that there have not been any significant surprises in stock investing in the United States. At least not for the long-term investor.

Productivity in the U.S. has been sufficient to support a stock return of 6.5 real going back a long, long way. So long as you adjust your stock allocation as needed in response to big price changes, this is what you get in the long term. Emotion sometimes pushes prices too high and you adjust your allocation down. Emotion sometimes pushes prices too low and you adjust your allocation up. It always works out fine for those who keep a long-term perspective and who do the math.

All of the “surprises” were experienced only by investors who believe in Buy-and-Hold Investing, or Passive Investing. Yes, this approach is full of surprises. That’s because it is a 100 percent emotional strategy. There simply is no evidence that valuations do not affect long-term returns. If you invest as if valuations do not affect long-term returns, you are going to be surprised over and over again. That’s one of the prices you pay for electing to by a Buy-and-Hold Investor.

Do you know any Rational Investors (those who adjust their allocations in response to big price changes) who were surprised by the stock crash? I do not. Robert Shiller saw it coming. John Walter Russell saw it coming. Rob Arnott saw it coming. Andrew Smithers saw it coming. Ed Easterling saw it coming. Jeremy Grantham saw it coming.

What made these people so smart? What made them so smart is that they looked at the historical data to learn how stock investing works before putting their money on the table. Buy-and-Hold Investing is fantasyland investing. I don’t mean to be insulting. But I have studied this in great depth and there is simply no evidence that valuations do not affect long-term returns. If you do not adjust your allocation in response to big price changes, you are taking an extreme long-odds bet (in my view!).

If we did away with the promotion of Buy-and-Hold, all investors would be open to investing rationally. Why wouldn’t they? Those who follow the Rational approach are able to retire five years sooner on average. If we all were Rationals, the market price would be self-regulating. Each increase in valuations above fair-value would cause stock sales and the stock sales would bring the valuation level back to fair value. All surprises would be gone.

Volatility is optional. Volatility is caused by emotion. Another way of saying it is that volatility is caused by the promotion of Buy-and-Hold Investing.

Rob