When I starting blogging, and started defending the EMH, I faced three anti-EMH arguments:
1. The obviously irrational housing price bubble.
2. The continual success of Warren Buffett.
3. The amazing returns earned by the hedge funds.
As you are about to see, all three critiques of the EMH have been recently discredited. Let’s start with the hedge funds. Here’s a recent article from the Economist, showing their early success was just a fluke:
Then there’s the amazing Mr. Buffett. Once again, the Economist comes to my defense:
Without leverage, however, Mr Buffett’s returns would have been unspectacular. The researchers estimate that Berkshire, on average, leveraged its capital by 60%, significantly boosting the company’s return. Better still, the firm has been able to borrow at a low cost; its debt was AAA-rated from 1989 to 2009.
Yet the underappreciated element of Berkshire’s leverage are its insurance and reinsurance operations, which provide more than a third of its funding. An insurance company takes in premiums upfront and pays out claims later on; it is, in effect, borrowing from its policyholders. This would be an expensive strategy if the company undercharged for the risks it was taking. But thanks to the profitability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period.
A further advantage has been the stability of Berkshire’s funding. As many property developers have discovered in the past, relying on borrowed money to enhance returns can be fatal when lenders lose confidence. But the long-term nature of the insurance funding has protected Mr Buffett during periods (such as the late 1990s) when Berkshire shares have underperformed the market.
These two factors—the low-beta nature of the portfolio and leverage—pretty much explain all of Mr Buffett’s superior returns, the authors find.
Then there’s the housing bubble. What goes up . . . stays up 4 times out of 5. That’s right, the housing bubble of 2005-06 was not something that would inevitably burst, as the anti-EMH proponents insist. Indeed if you look at the US, Britain, Canada, Australia and New Zealand, it is the US that is the outlier. All saw big price gains during the boom years, but only the US bubble burst. The other 4 countries still have very high house prices:
Inevitably some commenters will insist that the EMH is not true. Yes, but no economic theory is precisely true. However it is and will always be a very useful model.
Asset prices are unforecastable; but here’s one thing that can be accurately forecast: One hundred years from now all the top finance departments will still be teaching this theory that almost everyone insists is “false.” And yet 99% of the “anomaly” studies published in econ/finance journals and constructed through tedious data mining will be long forgotten.