A Concise Explanation of Efficient Markets and The Difficulty of Truly Beating The Market

Nate Silver uses the efficient market hypothesis (EMH) to demonstrate how our brains will use simplified models.

The simplified EMH - the simple statement in #1 below,  is often attacked by those who say that the EMH is invalid. But, by the time you read to #7 - which is a concise definition of the EMH, it becomes much harder to argue against the EMH.

The next time someone claims to outperform the market you should ask: Do they outperform relative to risk and transaction costs?

Nate Silver:

"Consider the following seven statements, which are related to the idea of the efficient-market hypothesis and whether an individual investor can beat the stock market. Each statement is an approximation, but each builds on the last one to become slightly more accurate.

1. No investor can beat the stock market.
2. No investor can beat the stock market over the long run.
3. No investor can beat the stock market over the long run relative to his level of risk.
4. No investor can beat the stock market over the long run relative to his level of risk and accounting for  his transaction costs.
5. No investor can beat the stock market over the long run relative to his level of risk and accounting for his transaction costs, unless he has inside information.
6. Few investors beat the stock market over the long run relative to their level of risk and accounting for their transaction costs, unless they have inside information.
7. It is hard to tell how many investors beat the stock market over the long run, because the data is very noisy, but we know that most cannot relative to their level of risk, since trading produces no net excess return but entails transaction costs, so unless you have inside information, you are probably better off investing in an index fund.

The first approximation—the unqualified statement that no investor can beat the stock market—seems to be extremely powerful. By the time we get to the last one, which is full of expressions of uncertainty, we have nothing that would fit on a bumper sticker But it is also a more complete description of the objective world."

Nate Silver (2012-09-27T00:00:00+00:00). The Signal and the Noise: Why Most Predictions Fail-But Some Don't (Kindle Locations 7462-7475). Penguin Press HC, The. Kindle Edition.