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

Part I

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 public information. 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.

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 not efficient 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 not 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?

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To be followed as projected below:

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