Efficient Market Hypothesis and Supermarket Lines

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I ran across another nice tidbit from the book The Undercover Economist by Tim Harford the other day, which like the concept of price targeting, also manages to involve supermarkets. I guess everyone goes to supermarkets. 🙂

In a chapter exploring stock market pricing, he covers the the idea of rational investors, the “efficient market theory”, and the related “random walk hypothesis”.

You can see the same phenomenon at work at the supermarket checkout. Which line is the quickest? The simple answer is that it’s just not worth worrying about. If it was obvious which line was the quickest, people would already have joined it, and it wouldn’t be the quickest any more. Stand in any line and don’t worry about it. Yet if people really just stood in any line, then there would be predictable patterns that an expert shopper could exploit; for example, if people start at the entrance and work their way across the store, the shortest line should be back near the entrance. But if enough experts knew that, it wouldn’t be the shortest any more.

The truth is that busy, smart, agile, and experienced shoppers are a bit better at calling the fastest lines and can probably average a quicker time than the rest of us. But not by much.

To me, this is a nice and simple way to explain the argument of efficient markets to say, a fifth-grader. If the market price of a stock was a lot lower than the “true” value, people would start buying, and soon the market value would equal true value. Even someone that young can appreciate trying to pick the shortest line, weighing the possibility of getting through quicker with the possibility of ending up actually waiting longer than if I had just stayed put. In the end, how much do you really gain on average?

Relative Efficiency

I would expand this analogy a bit further, however. In the stock market, if you can reliably “beat” the average person by just a few percentage points a year, you would become rich. Really rich. In the supermarket, the prize is a few extra minutes. I think people would agree that a lot more people around the world are trying a lot harder to get rich, than people are trying to get through the supermarket line. In the stock market, you’re trading against professional arbitrageurs and some supercomputer programmed by a genius hired by Goldman Sachs.

Imagine a supermarket full of world-class athletes connected via radio to spotters placed above each checkout line! This constant competition increases the “efficiency” of the market, and therefore makes it much harder to be above average.

Switching Costs

Despite the slight chance of improvement, I still like to try and find the shortest line at the supermarket. But what if I had to pay 50 cents every time I switched lines? I’d probably stay put.

This is similar to what happens when you try and actively trade the stock market. An actively managed mutual fund will cost nearly a full 1% of your total assets a year, while a passive index fund will be around 1/5th that cost (0.20%). Over time, that really adds up. If you do it yourself, you’re also looking at stock commissions. If you spent $10 a trade and bought $500 of a single stock a month, that’s a 2% hit for a buy, and 4% round-trip. High costs are the primary reason why you always hear that actively managed funds don’t outperform index funds.

In the land of investing, you can keep trying to pick the fastest line, but be realistic about the competition and watchful of your costs. By “staying put” with low-cost mutual funds, you’re guaranteed to be above average.

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  1. Great analysis.
    I think you mean to say If the true value of a stock was a lot higher than the market price, people would start buying, and soon the true value would equal market price.

  2. Your comments about actively managed funds and the cost go great with a link to an ebook that will be available for free through Oct. 1. I got the link from thefinancebuff.com:

    Investing Made Simple

  3. I’m a Super Market check-out lane Expert. Maybe I should sell a news letter on picking the correct lines at any given supermarket 😀

  4. I think anyone who agrees with this theory should stay with managed investments because they don’t really understand the market. A novice trying to find the ‘fastest lane’ will only end up with a hurt pride and less capital. The efficient market theory relies on the thinking that people are rational. People are not rational when it comes to risking money and when you get a group of people together as big as the market as a whole they become even less rational.

    Money in the market is made when inefficiencies are noticed and acted upon before they are closed.


  5. You do pay a price when you switch lines — you have to go to the back of the line. Great blog!

  6. but what about the express lane where you can only buy 12 items or less? is that where all the daytraders hang out?

  7. Scott – Good catch, I’ve corrected it so it sounds better (at least to me!).

    Robert – The books looks promising, definitely worth downloading while its free. How much for the newsletter?

    Bob – I agree people are not always rational, but actually making money on recognizing irrationalities is tough. Lots of people saw housing bubble in retrospect, but why then did so many hedge funds and others invested in such securities collapse?

  8. Your post reminded me of this: http://www.nytimes.com/2007/06/23/business/23checkout.html. Not relevant to your analogy, but interesting just the same.

  9. True, an individual may be hard-pressed to do better than the broad market, but that doesn’t mean you should just ‘stay the course’ regardless of market conditions. Jumping lines at Costco might not help me check out any faster; but I shop at 8pm on weeknights and stay away on Saturday afternoons.

  10. Very well put, although to me the correct analogy would be that instead of having to pay an extra 50 cents to switch lines, you always had to go in some sort of penalty box for 60 seconds before you switch. Afterall the unit in the stock market is money, and the unit in the supermarket is time.
    So Vanguard would be like the self check out lines, you do all the work on your own, but it’s quicker and there is less risk. Meanwhile in the Bernie Madoff line the bagboy drops a 24 pack of soda on your 2 dozen eggs.

  11. You definitely get a feeling for the way the lines move, especially at like Target. You can tell by watching for about 20 seconds which is the preferable line. If only it took such little effort to understand stocks. There you’ve got thousands of lines, crazy people jumping in and out of all them and other people giving you advice about each line which is sometimes completely wrong.

  12. Efficient markets is an interesting hypothesis, and I believed it for years. But, as indicated by two enormous bubbles over ten years, human nature seems to show us otherwise. A better analogy might be:

    You spot a hurricane (let’s call it ‘Katrina’) coming, but you’re not sure when is going to hit, but you’re a smart person and have spent your time studying these storms, and you think there is a string chance it will hit around New Orleans, which happens to be where you live. You mention this to a few friends, but they say “don’t worry about it, they always miss, plus the National Weather Service doesn’t have any warnings out, so stop being chicken little. Look, it’s not even that big of a storm. One came just last year and it hardly did anything.” But you know from your own study that it has a good chance of growing quickly, and if it hits, you would want to have taken some preparations. So, before you can be sure it will hit your town, but based on your research, you decide to go do some bulk grocery shopping, just in case. The lines are short, and it’s easy to get out of the store. You get in and out quickly, buy lots of food, supplies, etc. You’re ready, just in case, so you won’t need to visit the store again for weeks.

    As the storm approaches and it becomes obvious that it is going to be a big one, suddenly panic ensues and everyone goes shopping and the lines at the grocery store are as long as they can be. The store runs out of food and everyone can’t get what they came for. Some people leave the store with nothing at all. Traffic jams on the freeways as thousands of people try to flee at once. Don’t worry, the experts say, that’s what the levees are for. They’ve never broken yet, so why should they now? This thing will just pass over and before you know it things will be back to normal, the shelves will be restocked, and you’ll be able to get all the food you need. Just go to the football stadium downtown, hunker down, and wait it out.

    The storm arrives and departs, and we know what happens. The person with some foresight into a serious possible risk finds himself well supplied and (comparatively) easily able to cope, while others are desperate and hungry. How can this happen with an efficient market? Didn’t everyone know what might happen? Shouldn’t everyone have been prepared? In hindsight, yes everyone should have known. They all knew they lived in a hurricane risky area. But did they all act and prepare as they should? That isn’t efficient at all.

    The moral of this story is, while you might not be able to pick the fastest line, you certainly know what day you should be, and should not be, at the store. The single insight about this one storm has saved you more time and money than any incremental improvement over picking a faster line during your regular grocery trip. Human nature and history shows us that, despite apparently obvious risks, people behave in predicable fashion: lack of preparation, and panic when it is too late. With this information, if you can prepare rather than panic, you will be able to outperform your peers over the long term, whether in stocks or anything else.

  13. Using the same analogy, I do not switch lanes on a busy highway just because other people keep switching around me. If the right lane is really moving faster, soon my lane will be free because everyone else is going to the right lane!!

  14. Thats a decent analogy.

    However, it fails largely when you compare the length of a line and about how long it will take to go through that line to the value of a company. The properties of a line are known and relatively objective while the value of a company is largely subjective. Also, the herd mentality with buying stocks is stronger.

    Let’s say someone is better than most at seeing the true value of a company is better than most, he or she invests unemotionally, has enough money to make researching worthwile, and has enough time to do the necessary research. This someone would be able to make significant money investing in undervalued companies. This probably fits less than 1% of the investors out there.

    Therefore, it is still better for most people to follow the conclusions of the analogy and just regularly buy low cost index funds and get back to your life.

  15. Mississippi Mike says

    Hey Jonathan, great post.

    Few individual traders will spend $500 on a trade. $5000 is closer to reality (note that I didnt say it was reality). If this is true then your costs are now 0.02% instead of 2%.

    Index funds are great, just dont buy them when the market is overvalued, or you could become a very long term long term inverstor. 🙂

    People are not rational! Our government (current and past (and future) )and the people who vote for them is painful proof of that.

    In addition to being an expert in the stock market, I am also an expert in picking lines at the supermarket. By this I mean that when I buy a stock, it goes down, and when I join the fastest line at the supermarket, it immediately slows or stops and the other lines go faster! There is no mathematical law to explain my consistency in this – (well ok there may be 1 or 2 Irish mathematical laws).


  16. I’ve had this problem lately… You pick the line with the least number of items in front of you, but then one person has food stamps and takes 10x longer than anyone else would. Makes me feel there should be a food stamps line… or a food stamps store! Sorry if this sounds insensitive, but I think I’ve lost at least an hour of my time over the last year due to this.

  17. I think you would want to go into the store when everyone else is panicked and the store is empty.

    You’re probably right that it may not do a lot of good to try to outwit people during the busy hour.

    Buffett says efficient market theory is non-sense. Why is he wrong and your right?

  18. Actually, Buffett has stated many, many times that the best advice for the common investor is to buy low-cost index funds. He’s even placed a $1M bet with top hedge fund managers (with aforementioned high costs) that a Vanguard index fund will win out over a long period of time.


    Markets aren’t perfectly efficient, at least I don’t think so. But look in a mirror. If you aren’t Buffett, you have to admit the chance that the odds are against you. 😉

  19. I like the econ posts! Knowledge to masses, power to the people. =)

  20. “Actually, Buffett has stated many, many times that the best advice for the common investor is to buy low-cost index funds.”

    You’re right about that. However, we weren’t talking about whether or not he recommends index funds; we were talking about if he believes in efficient market theory…He doesn’t.

    Read “The Superinvestors of Graham-and-Doddsville”.

    The bet that you reference is after fees. You don’t pay 2 and 20 when you manage your own money.

  21. Mississippi Mike – “Most” people don’t even max out their Roth IRAs every year, so I doubt they are making $5,000 trades on average. Besides, if you have $25k, you can trade for free at Zecco and Wells Fargo. 🙂 I wonder, what percentage of Americans have $25k in a brokerage account?

    Jack – I have read that article, it is definitely a good read. A youngish and snarky Buffett, very fun! There are many forms of the efficient market theory, but I’m not really into all those “strong-form” or “weak-form” definitions. Buffett thinks that there are inefficiencies, and so do I. He thinks the vast majority of investors can’t reliably and over time take advantage of these inefficiencies, and so do I. And as to the bet, he thinks that the *experts* who get paid millions and millions can’t beat it by 2+20. To me, that is the efficient market theory.

    If you read through his autobiographies and other interviews, I think you’ll agree that he thinks markets are more efficient now than before (like when he wrote that article). You can’t go out and buy a company for below book value nearly as easily as when Graham was writing Intelligent Investor.

  22. Jonathan — long time reader (but lurker vis-a-vis comments) of your blog. I don’t think markets are efficient because stocks tend to go up when an analyst makes a favorable report about a company. That’s not “new news” about company performance — it’s just analysis about what one analyst thinks about the existing news about company performance. People should be ignoring analyst upgrades/downgrades under the hypothesis.

    I also think there are lots of herd-think effects that go on with the stock market too (and certainly thought that before the most recent market events). Herd-think definitely adds lots of inefficiencies — think everyone at the supermarket had this idea that checker #7 was the fastest, even if it wasn’t true.

    Re: what you said about Graham — there weren’t as many analysts either during his time. So it was a lot easier to find inefficiencies, even for larger companies. That has changed as larger companies have gotten larger and receive more coverage. The thing is, you can still *easily* buy companies for below book value when there aren’t that many people following them. Think microcaps. There are lots of inefficiencies considering how infrequently microcaps are traded.

  23. “If you read through his autobiographies and other interviews, I think you’ll agree that he thinks markets are more efficient now than before (like when he wrote that article). You can’t go out and buy a company for below book value nearly as easily as when Graham was writing Intelligent Investor.”

    I disagree. In March you could have bought a large number of companies below book value. You also could have found quite a few that were trading below net cash.


    You have said that the last 50 or so years were a unique time for investing in American securities markets—numerous mis-pricings. Do you believe that something like this will happen again? And if you were 26 today and you had only a $1,000,000 how would you generate the 50% returns that you said you might do with smaller amounts of capital?

    Attractive opportunities come from observing human behavior. In 1998, people behaved like frightened cavemen (referring to the Long Term Capital Management meltdown). People make their own opportunities. They will be frozen by fear, excited by greed and it doesn’t matter what their IQ, degrees etc is. Growth of 50% per year is with small capitalization, not large cap. The point is I got rich looking for stock with strong earnings.
    THE LAST 50 YEARS WEREN’T UNIQUE. It’s just capitalizing on human behavior. It’s people that make opportunities when others are frozen by fear or excited by greed. Human behavior allows for success if you are able to detach yourself emotionally.

    In 1951, I got out of school at 20 years old. At the time there were two publishers of stock information, Moody’s and Standards and Poor’s. I used Moody’s and went through every manual. I recently bought a copy of the 1951 Moody off of Amazon. On page 1433, there’s a stock you could have made some money on. The EPS was $29 and the Price Range was from $3-$21/share. On another page, there is a company that had an EPS of $29.5 and the price range was $27-28, 1x earnings. You can get rich finding things like this, things that aren’t written about.

    A couple of years ago I got this investment guide on Korean stocks. I began looking through it. It felt like 1974 all over again. Look here at this company…Dae Han, I don’t know how you pronounce it, it’s a flour company. It earned 12,879 won previously. It currently had a book value of 200,000 won and was earning 18,000 won. It had traded as high as 43,000 and as low as 35,000 won. At the time, the current price was 40,000 or 2 times earnings. In 4 hours I had found 20 companies like this.

    THE POINT IS NOBODY IS GOING TO TELL YOU ABOUT THESE COMPANIES. There are no broker reports on Dae Han Flour Company. When you invest like this, you will make money. Sure 1 or 2 companies may turn out to be poor choices, but the others will more than make up for any losses. Not all of them will be good, but some will and those will make you rich. AND THIS DIDN’T HAPPEN IN 1932, THIS WAS IN 2004! THESE OPPORTUNITIES WILL BE THERE IN THE NEXT 30 YEARS. You’ll have streaks where you’ll find some bad companies and a few times where you’ll make money with everything that you do.

    The Wall Street analysts are brilliant people; they are better at math, but we know more about human nature.

    In your investing life you will have several opportunities and one or two that can’t go wrong. For example, in 1998 the NY fed offered a 30-year treasury bonds yielding less then the 29-½ year treasury bonds by 30 basis points. What happened was LTCM put a trade on at 10 basis points and it was a crowded trade, they were 100% certain to make money but they could not afford any hiccups. I know more about human nature; these were MIT grads, really smart guys, and they almost toppled the system with their highly leveraged trading.

    This was definitely a good time to act.

    What is your opinion on exchange-traded funds and how to do you accurately judge them?

    ETF’s are a fairly low cost way to get into a market or industry. We don’t hold any and never will. I recommend index funds for people who don’t want to spend time studying the market. They are good for 95% of the population. If you don’t bring anything to the game, you shouldn’t expect to win.


    -Buffett on the death present

  24. The book says “The simple answer is that it’s just not worth worrying about. ”

    Whether you are talking about the cash register, the freeway, or your IRA it is simply so true.

    Really, think about it, over the long haul does it really save time to switch register lanes? It may seem like an eternity when you are standing there but it really isn’t. Which lane do ou think you’ll be faster than, anyway? Put the time to good use or just ignore the other lane. How many times do you just happen to pick a faster lane? Ours brains react more to “bad” things than to “good” things.

    I’ve seen studies that analyzed the behavior of changing lanes on a jammed up freeway. You change into the lane that seems to be moving a little quicker. Guess what? The only reason it’s moving quicker is because someone a few cars in front of you switched into YOUR lane. The fast way is to pick a lane and stick to it. Turn up the tunes and enjoy the ride. Sure, you can get into the breakdown lane and pass everyone, but you might get caught.

    Same with investing. If active traders really made more money, don’t you think everyone would be doing it? Study after study says they don’t! If the get rich quick authors got so rich, why are they pedaling books/seminars? Because they like you? If stock advisers & analysts are so smart, why don’t they keep the research to themselves and get rich on it?

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