Investment Philosophies: Successful Strategies and the Investors Who Made Them Work, 2nd Edition

CHAPTER 6

Too Good to Be True? Testing Investment Strategies

As investors, we are constantly bombarded with sales pitches from experts claiming to have found the secret formula or the magic model that guarantees investment success. Buy stocks using this strategy, they say, and you will get a portfolio that has low risk and high returns. While you do not want to rule out the possibility that such strategies exist, it pays to be skeptical. In this chapter, we look at how to test investment strategies. In the process, we will also examine what we mean when we say that markets are efficient and cannot be beaten or that markets are inefficient and can be beaten.

Market efficiency is a concept that is controversial and attracts strong views, pro and con, partly because of differences about what it really means, and partly because it is a core belief that in large part determines how an investor approaches investing. We provide a simple definition of market efficiency and consider the implications of an efficient market for investors.

WHY DOES MARKET EFFICIENCY MATTER?

The question of whether markets are efficient, and if not, where the inefficiencies lie, is central to choosing your investment philosophy. If markets are, in fact, efficient, the market price provides the best estimate of value, and the process of valuation becomes one of justifying the market price. As an investor, you would not then try to pick undervalued or overvalued stocks or try to time the market. Instead, you ...