Is it possible to identify undervalued stocks ahead of time? Some people believe that that free markets fail and it is possible to identify in advance which stock prices are inaccurate. Those who believe this are referred to as active investors or active money managers.
On the other hand there are those who believe that free markets work. Eugene Fama in his Ph.D. dissertation, said: “In an efficient market, at any point in time the actual price of a security will be a good estimate of its intrinsic value.” What this means is that all the knowable and predictable information is already factored into the price of a security. In other words, it is breaking news or information that changes the price of a security. It is impossible to predict what new news and new information will be.
Fama is correct about his view of the efficient market hypothesis, we know that based on supply and demand, the free market is the best determinant of market prices. All available information is factored into the current price. Only new and unknowable information and events change pricing in the future. The randomness of the market makes it impossible for any individual, entity, or software program to consistently predict market movements and capture additional returns unrelated to risk. To help make this point, take an actual look at market returns.
The returns of the above asset classes are very impressive. These returns tell us that free markets do work without any stock picking or market timing. It is better to own an entire asset class in a portfolio then to try and pick stocks within an asset class.
To learn more about how to own an asset class please click here.
1 Eugene F. Fama, “Random Walks in Stock Market Prices,” Financial Analysts Journal, September/October 1965
2 Past performance is not indicative of future results. Indices are unmanaged baskets of securities in which investors cannot directly invest. Assumes reinvestment of income and no transaction costs or taxes. US large-cap stocks are represented by the CRSP Deciles 1-5 Index, US small-cap stocks by the CRSP Deciles 6-10 Index, US large growth stocks by the Fama-French US large growth index, US large value stocks by the Fama-French US large value index. Full descriptions of indices used above are available upon request. 37 year performance figures taken from Dimensional Fund Advisors, Inc. Returns software 12/09. Some data provided to DFA by the Center for Research & Security Pricing, University of Chicago. January 1, 1973 – December 31, 2009