Markets Are Not Always Efficient
Last week we introduced you to the “Seven Things Every Investor Should Have Learned From 2008”. Today we will discuss one of them and what you need to do because of this information.
Financial professionals have long preached to buy and hold a diversified portfolio to achieve long-term objectives, but the soundness of that advice is being called into question. The strategy, called Asset Allocation, is based on the assumption that markets are efficient and that price movements follow a normal distribution – both theories that are discredited by the current market volatility.
The Efficient Markets Hypothesis, one underlying theory of Asset Allocation, states that all information relevant to a security is quickly factored in to the price. This hypothesis implies it is impossible to find inefficiencies in the market, suggesting that Asset Allocation should be an investor’s sole investment approach.
It turns out there are inefficiencies, which the recent market meltdown has exposed. For example, it was widely know that Lehman Brothers held large quantities of essentially worthless toxic assets, but the stock price still hovered in the double digits until right before the company went under, when the price dropped to a level that more accurately reflected the situation.
Not only has the recent market revealed inefficiencies, but the swings in prices have not followed a normal distribution. In October 2008 there were five days of moves over five percent in the DJIA - an occurrence only supposed to happen every 5,000 years, according to a normal distribution.
Investors who employ a single strategy of Asset Allocation with its mantra of “buy and hold” may encounter larger changes in their portfolio values than what they are willing to tolerate. A multiple management style is called for. “Staying the course” with your entire portfolio without making adjustments to macroeconomic trends – is risky.
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