Are there areas of the stock market where stock prices are not efficient and skillful investors can scope out bargains overlooked by other investors?
That argument is commonly used to justify active stock selection among small stocks and emerging-market stocks.
It appears that more investors are conceding that prices on big U.S. and overseas developed market stocks are probably efficient because there is so much competition among investors that all relevant news is priced into the market. Any individual investor’s information on a particular stock is already factored into its price. If this is true, an investor is better off using an indexed mutual fund for large U.S., European and Asian stocks.
But many claim that smaller markets—like small company stocks or stocks of emerging markets such as Brazil, Poland and India—are inefficiently priced. However, two top investment academics say that there is no evidence to support this view. Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College made their reputations studying the returns of small stocks.
One argument for inefficient small stock prices claims that small stocks are often neglected. If few people are paying attention to small stocks, the argument goes, how could their prices possibly be accurate? Kenneth French responds that this argument “may have had some merit 150 years ago” but is out of date in an era where “hundreds of billions of dollars” are spent by investors each year looking for pricing errors.”
When it comes to emerging markets, the argument is that stocks in some markets are ripe for the picking because these investors are just not as sharp as the rest of us. But according to Eugene Fama, that argument is flawed: “People are bright and highly motivated in markets around the world,” making those markets efficient too.
Be cautious of active stock picking. Consider the benefits of index investing.
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