Dynamic Asset Allocation Modern Portfolio Theory Updated for the Smart Investor

Chapter 4. Rethinking Random Walks and Efficient Markets

Judging by Samuelson's and Fama's seminal 1965 papers on the efficient market hypothesis (EMH), investing is simple. Perhaps too simple.

The simplicity arises from the idea that price changes are random. They're random because the primary catalyst behind fluctuating prices—new information—arrives haphazardly. News is unpredictable, erratic, and more or less arbitrary in its debut on the world stage. The best estimate of future prices, then, is the current market price. Some of the forthcoming news will raise prices, some of it will lower prices, and some will elicit mostly yawns. But if we can't routinely predict the news, then hedging our bets by riding with the market is attractive in the long run.

If the fundamental driver of new prices arrives randomly—news—it follows that price changes will be random. As we learned in a previous chapter, Fama's research tells us that a careful study of the evidence suggests no less.^[67] Meanwhile, Samuelson (1965) lays out a proof that "properly anticipated prices fluctuate randomly."

By that standard, there's no point in trading for reasons based solely on price forecasts. The exception is if an investor is in possession of relevant information not generally known to the market. Otherwise, if expected prices are as likely to rise or fall, and if no one has reliable insight about the future, intelligent investors should favor middling results over time. In that case, logic suggests buying ...