Value Investing and the Death of Efficient Market Theory

This article by Joseph Nocera about the recent annual Graham and Dodd breakfast at Columbia University brought up a few interesting things that I hadn’t read too much about before, mostly concerning the theory behind how 95% of the world invests today. Apparently most business schools across the United States teach Modern Portfolio Theory as a way to minimize risk in a portfolio. It (MPT) holds that because the market is efficient (an assumption), it cannot be beaten, and therefore the only way to minimize risks and maximize returns is through diversification. This is essentially the theory from which banks and other financial managers from all over will tell you things like “Experts agree that the asset mix of your investments – safety, income and growth, account for more than 80% of your portfolio’s return.” This statement doesn’t even make sense to me, although I have sort of accepted it gospel for a long time, since it was posted on TD Canada Trust’s website, and of course the big banks know everything.

Bruce Greenwald, who runs a value investing course at Columbia, like Benjamin Graham and Robert Heilbrunn before him, says that “efficient market theory is basically dead.” Warren Buffet says modern portfolio theory is akin to the theory that the “world is flat.” Well that was enough for me… I guess modern portfolio theory is just a theory and the efficient market hypothesis is just a hypothesis.

There is also talk in the article about why value investing is so unpopular, even with the success of Buffett and Graham and many others and the fact that studies that have been published which show that “a portfolio of value stocks generally outperformed the market.” There are many reasons given. Jason Zweig (who wrote the updated in comments in Graham’s latest Intelligent Investor), says that value investing is “just plain hard,” (ie. takes a long time pouring over statements) and others say that there simply aren’t as many value stocks out there these days (could be true, if you look at the long term trend in P/E ratios). But Jean-Marie Eveillard, a successful value mutual fund manager said what Joseph Nocera thought was the best answer, that “It goes against human nature . . . You have to be very patient. You’re not running with the herd — and it’s much warmer inside the herd.”

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