The Efficient Market Hypothesis (EMH) is a controversial theory within the world of economics and investing. First established in the 1960s, the theory has been hotly debated for decades among investors and economists alike with evidence to support both sides of the argument. The recent increase in the influence of the idea can be seen by the many investors who have flocked to passive index funds as opposed to more traditional forms of investing. With the emergence of technologies that bring the entirety of human knowledge to the palm of our hands in an instant, the principles of the theory become more and more applicable. So what is EMH? Is it accurate? And how does it apply to real estate investing?

So what is it?

Simply put, The Efficient Market Hypothesis postulates that due to the wide availability of information, the speed at which information spreads, and the millions of rational, even-keeled investors participating in the market stocks will always be priced at their intrinsic value. There are far too many people studying prices, trends, and financial news for any bargains to be available. Therefore, the theory states, it’s impossible to consistently beat the average over long periods of time (which is why subscribers to the theory like passive index funds) because securities’ prices remain at intrinsic value and consequently investors cannot buy at a discount. Proponents of the theory cite decades of data showing that many professionally managed funds do not outperform the average over the long-term and many funds that have a few good years ultimately regress to the mean over time. But are investors really rational? And how can you explain economic bubbles if prices are always at intrinsic value? This is where the theory begins to break down.

Rational investors?

One of the most significant critiques of EMH comes from behavioral economists who make the point that most investors are not rational and make the majority of their decisions with their emotions (even though they think they’re using logic). This is exemplified in the consistently recurring bubbles throughout economic history (see our recent blog How much Optimism is Factored into the Price? for a discussion on this) which are always the result of irrationality and lead to prices far above intrinsic value at the peak of the bubble and far below after it pops. Time and time again, investors create frenzies around securities that they believe to be (seemingly) infinitely valuable which pushes prices up and up and leads to other investors getting FOMO until they eventually capitulate and buy which pushes prices up even further past intrinsic value. This is not rational behavior, which is exactly why EMF is not accurate in every circumstance.

However, with the proliferation of technology and the minute by minute updates on prices and world news it is more difficult than ever to buy a stock at a discount. Again, it’s true that investors are not always rational, but in today’s world there are millions of additional investors who have access to information/pricing at the palm of their hand relative to just a few decades ago. Competition in the world of investing has absolutely gone up and when a company’s stock is priced below intrinsic value it does not last long. There are investors who have consistently outperformed the stock market over several decades (see Warren Buffet, Howard Marks, etc.) but they are few and far between. The reality is that The Efficient Market Hypothesis is not applicable to every circumstance and securities do sometimes drift below or above intrinsic value BUT it’s extremely difficult to buy them at a discount and even more challenging to do so consistently for decades at a time. This is exactly why so many people have given up trying to beat the market and have opted for index funds. They know that (historically) they can expect to have an overall positive gain if they leave their capital in these funds over long periods of time. Most investors who achieve returns above the average do so throughout bull markets only to lose all of their gains (and often their capital) when a recession hits which leaves them right back where they started. The bottom line is that few investors can prove EMF wrong when investing in the stock market and most would be better off just investing in index funds. 

How is this applicable to real estate?

This is where one of the biggest advantages of real estate investing comes into play, when investing at an individual level The Efficient Market Hypothesis is inaccurate far more frequently than when investing in other assets! There are no stock tickers for real estate that are updated by the minute that everyone has access to. There are many geographical areas with little competition from other investors. There are subsets of the asset class (mobile homes parks and storage units are two examples) that are still largely owned by mom and pop investors with little institutional competition. These factors (and many more) come together to create a situation where you can consistently buy assets SUBSTANTIALLY below their intrinsic value. Even better, this can be done without having a massive amount of capital available or being exceptionally intelligent.

What happens when a house goes into probate? When an investor moves and tries to manage their rental from another state what is typically the end result? What do sales at foreclosure auctions look like? The end result in the aforementioned scenarios is the sale of real estate at a substantial discount from its intrinsic value! These are just a few of the numerous scenarios where property is available for purchase at bargain prices. Every day a new situation is created where someone is willing to sell their property for a discount in order to avoid dealing with one problem or another. The bottom line is simple, there are far more opportunities to buy real estate at a discount than there are with other assets allowing investors to achieve superior returns for years on end.