Contrib. 1c2: How efficient are markets?
by Leif Ericssen (presentation started June 2000)
Part I

   1. The market efficiency thesis

The efficient market hypothesis (EMH) is a theory developed in
academia in the mid-1960s.

It holds that all securities are priced rationally in the market, that is,
that prices fully reflect all available information.

Because all information is contained in stock prices it is impossible

to beat the market over time without taking on excess risk. (Please
note that the EMH was first formulated about the stock market
but is considered to apply to all financial markets.)

Competition between rational investors keeps prices about where
they should be. As all information that determines stock prices are
analyzed by numbers of investors, stock quotes reflect the best
estimates of their value. Prices may not always be right, but they
are unbiased.
So if they're wrong, they're just as likely to be too high as too
low compared to a kind of optimal value.

Because the market is efficient, investors should expect only a fair

return relative to the risk of purchasing a particular stock.

Risk is defined as volatility. The greater the volatility of the
stock or portfolio compared to the overall market, the greater
the risk. Since the market efficiently values risk and return,
securities with greater risk should provide greater rewards.

1b Strong and weak forms of EMH

  Strong form of EMH. The assumption is that market prices constantly reflect the net
intelligence of all the many participants acting independently, and so its evaluation is better

than that of individuals.

Thus, the market's pricing of an item is the best estimate of its value.  So, the
market is an arena where many rational, profit maximizing investors, with roughly
equal access to information, are competing in trying to predict the future course of
prices - and cancel each other out.

The market reacts immediately and correctly to new information as it arrives. Thus
investors cannot benefit from it. An investor can't beat the market using publicinformation.
If one does, it's sheer luck. This  is what is known as the strong form of EMH.

Weak form of EMH. It is related to the random walk concept. It states that "prices
have no memory and yesterday is unrelated to tomorrow".
Meaning that records of past
prices can't be used to predict future prices and that it's impossible to time the market.

Briefly, the many competing participants acting at various times should cause the actual price
of a security to wander randomly around its equilibrium price level. This optimal level
itself will change over time, in response to new information as it sporadically shows up. No
one knows what new data will enter the market, if it will be positive or negative, or whether
it will affect the market as a whole or only a particular security.

1c A first appreciation : if the strong form may be hard to swallow...

According to the strong form of EMH, market prices are assumed at any given time to
reflect fully and realistically all that is known about the firm. There is no way bargains
can be found using public information, since the favourable influences that make a potential
buyer believe that an attractive situation exists are already reflected in the price of the stock.

The implication is that investors are rational and select investments based on objective
appraisals of potential risk and rewards. This is a play on the rational homo economicus
decision-maker
assumed to exist by economists in their models that try to explain and
predict economic activity.

A lot of people - myself included - instinctively reject the strong form of EMH.

People just don't like the idea that beating the market is beyond their reach. What
good are your best efforts and intelligence if they won't put you ahead in the game? The
thing about believing in efficient markets is that you have to give up your pride.

For professional investors (people whose chosen profession is investing other peoples'
money) in particular, Efficient markets would make what they're doing meaningless.
They can hardly be expected to admit that picking stocks with darts would do as well.

Most investors, private or professional, believe that an investor of high intellect can
consistently outperform the market. But of course, we all think we're of high intellect.
If you had 100 members of Mensa investing, they may all believe they could beat the
market. "Smart money" probably has much less to do with IQ levels than smart people
might think.

1d ...the weak form may have its virtues

Furthermore, those with the most objection to EMH quite likely have the least
comprehension of it. In fact, generally speaking, the weak form of EMH seems true.
Past price movements don't profitably predict future changes. Investors do better to
buy and hold stocks rather than trade a lot. Short term trading runs up high taxes and
transaction costs.

This seems to debunk most technical analysis. A thing that studies past patterns in
charts of stock prices, trading figures, and/or statistical indicators in an attempt to
predict future price changes. ("Technical" refers to the dynamics of supply and demand
within the market in terms of price/volume.).

Most extreme in this are the chartists that look at graphs of prices and read patterns
into the squiggles in search of the future trends. Charting is feeble when it comes to
results or even providing a commonsense explanation of why it should work.

Interestingly, chartists account for a large percentage of trading in futures, and they
often amplify market swings, creating self-fulfilling prophecies.

Chartists may be dismissed as the fringe. But many mainstream investors, both
private and institutional, use market timing, often in the form of "asset allocation"
strategies.
The cumulative results in this decade for mutual funds practicing market timing
average less than 2/3 that of a buy and hold approach in the market before taxes.

Academic studies using computer-run statistical analysis have failed to identify
technical trading methods that work well enough after taxes and transactions costs
to provide an attractive profit relative to the risks taken. Of course, there are brief
patterns in daily and weekly price movement due to adjustments in prices in
response to momentary changes in relative buying and selling pressures. But it seems
that only market makers on stock and futures exchanges can exploit them.
As they're free of the transaction costs they charge outsiders and can move quicker.

   2. The Case Against Efficient Markets

So, we see that the assumption of rational investor behaviour is at the core of EMH.
What discredits it most is that cognitive biases and social and crowd influences can
sometimes dramatically skew our perceptions, leading to disastrous decisions.

People simply:

don't gather and process information in an unbiased way,

attach undue importance (or unimportance) to recent or extraordinary events,
   distorting reality in the process.

attach undue or unexamined value to certain desirable or undesirable events.

So, the standard argument against EMH goes something like this: the stock market is
notefficient because there are many bad opinions, incorrect interpretations, and
emotions
such as pride, doubt, fear, and hope. Sometimes there are simply bad or
shallow judgments, numerous complex variables, and fast-changing events, which
investors do ot properly weigh. Even when they possess all relevant information,
which is the exception rather than the rule.

Basically, the market is not efficient because too many wrong opinions and strong
investor emotions can create trends sending stocks far below or above reasonable
values
.

To all this, one can reply that markets may be characterized by irrational individual
behaviour, but it cancels out in the aggregate. Thus leaving the lowest common
denominator of rationality as the key behavioural component.

Indeed, one possible definition of rational behaviour is independence across individuals.
This is a fair point, but it shifts the issue from "are markets efficient?" to "how efficient
are markets?"
, which is acceptable to economists. It also raises the scenario of "limited
efficient markets
", where price and value tend to converge, but markets can still move far
from reality at times.

This opens the door to discovering explanations of market anomalies and how they evolve.
This is the main research topic in behavioural finance. Some BF people go further, saying
these anomalies are the rule. They consider the optimal equilibrium as rarely found in
the real world, and the models based on this "strong" EMH approach as just "central
limit cases". For them, the right scientific approach starts by studying investors
behaviour.

See also:  do investors biases cancel out?


To be followed as projected below:

Other topics (under preparation) in part I would be:

   3. Are Investors rational?

Here are first elements about some "behavioral biases / heuristic biases" maybe
caricatures as things are kept short) taken from a b-f definitions  page. Also a lot
of debates took place and are taking place in the behavioral-finance group.

* Anchoring / adjustment / cognitive dissonance. People have in their mind some
reference points (anchors), for example a previous stock price. When they get new
information, they adjust this past reference insufficiently (under-reaction). This has
some similarity with cognitive dissonance that means people have a tendency not to
accept fully (or even to reject) new facts that are contrary to their belief.

* Overconfidence means that individuals overestimate their abilities and knowledge /
information. This, coupled with anchoring, can explain differences of opinion and high
trade volume among investors.

* The hindsight bias concerns people having forgotten their original estimates. When
they see the outcome, they are likely to use it as an anchor and assume their estimates
must have been close to it.

* Social psychology is another crucial factor of behavioral biases (mimicry...)

  4. What does it matter? (private / public perspective)

Part II would include:

Implicit assumptions behind early EMH models.

What is Risk? Is it just statistical volatility?

Efficient Markets - Pros and Cons.

Part III would deal with:   Possible approaches to beat the market

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