Showing posts with label Efficient Market Theory. Show all posts
Showing posts with label Efficient Market Theory. Show all posts

Thursday, April 10, 2014

Efficient Market Theory


You may have heard of something called the Efficient Market Theory. If you did, it was almost certainly in a negative context, some writer or blogger excoriating those egghead finance professors for confusing the world with their crazy and dismal theories. This is a rant mostly heard from the advocates of investing in individual stocks, but is also found occasionally in the arguments of those in favor of active funds over passive (index) funds and market timing over passive asset allocation.
Apparently, this poisonous heresy has been spread by overly educated academics near and wide for decades. They convince their innocent students that it is categorically impossible to make money picking stocks, that anybody who does anything other than buy an index fund is a fool. It’s a viewpoint that is not just wrong, it’s dismally pessimistic and, let’s face it, simply un-American.

The efficient market theory states that the stock market reacts very quickly to new information, so at any given time the market contains the sum of all investors’ views of the market.

What does this mean to the average investor? Imagine you are reading an article in the Wall Street Journal. Dell is going to release a new computer in three months that will blow away the competition. You think maybe tomorrow you’ll call your broker and buy Dell, because obviously the price will go up.

The efficient market theory states, in no uncertain terms, you are too late! If you bought Dell stock as soon as soon as you read the article, or even as soon as it was printed, you are still too late. A lot of more savvy investors and traders bought the stock before you, and drove the price up. It doesn’t matter that the new computer won’t be released for 3 more months. Whoever buys the stock first wins.

What does this mean to the savvy trader? Even if you have the fastest tools and the best information, you still have to work for it. Trading is a competition. No strategy will always work. That’s impossible, because in order for someone to win, someone else has to lose.

An oxymoron is a figure of speech that deliberately uses two contradictory ideas. This contradiction creates a paradoxical image in the reader or listener's mind that generates a new concept or meaning for the whole. Some typical oxymorons are:

  • a living death
  • sometimes you have to be cruel to be kind
  • a deafening silence
  • bitter-sweet
  • The Sounds of Silence (song title)
  • make haste slowly
  • he was conspicuous by his absence


Recently the efficient market theory has been misquoted a lot. The efficient market theory does not say that the market is always correct. It says that the market represents the sum of the information available and the choices made by traders and investors. Traders and investors can be wrong. Information can be wrong. The best opportunities come when the market is temporarily wrong. The smart traders will find the difference between the market value of a stock and the ideal value before the rest of the crowd does.

One successful strategy that many of our customers use is called “mean reversion.” This strategy is based on the idea that the market is not 100% efficient. Time after time, the market will overreact to bad news. Prices will move much further than they should. Then they will move back toward normal.


A MARKET EFFICIENCY STORY

An elderly economics professor was walking down a busy street with one of his energetic students to the local café for lunch. Along the way, as he was explaining the concept of market efficiency to his student, the professor stepped right on a wadded up $20 bill and continued to stroll on. The student, who was looking down in studious thought at the time, was amazed at his good fortune and stooped down to pick it up. As the student rushed to catch up with the professor, he asked the professor whether he had seen the $20 bill.

The professor quipped "My dear lad, haven't you been listening to anything I have been saying about efficient markets? Although I saw the $20, I knew my eyes must have been deceiving me. Efficient markets theory dictates that it couldn't possibly be there because if it had been, someone else would have already picked it up."

The story above is an old joke among economists. It highlights both the conclusions and possible folly of assuming the extreme case of efficient market theory. Most scholars believe (in one form or another) in efficient markets. Although there are several forms of what is referred to as the "market efficiency hypothesis," its basic premise is that all stock prices accurately reflect all historical and current information. This means that whenever you purchase a stock, you are getting the best price based on available information. If the stock you chose was truly undervalued, investors would have already been buying the stock and thus pushing the stock price up until it was considered accurately valued. The opposite occurs for overpriced stocks. In essence, the theory states that there are no $20 bills, or even $1 bills just lying around for you to pick up. When was the last time you found a $1 bill lying around? This is market efficiency at work.

In support of this theory, many studies have shown that picking stocks by throwing darts at the stock table is just as likely to earn you profits as listening to the "market experts."

EMH was conceived as a null hypothesis in the 1950s and 60s. On the slim chance that you are unfamiliar with the term, I will summarize. A null hypothesis is a reasonable, obvious, and often naive interpretation of data to explain what is going on. You invent it as the alternative to the new clever theory you are trying to test. “The Earth is flat” and “heavier objects fall faster than lighter ones” are examples of great null hypotheses from history. A key thing to remember about null hypotheses is that they do not need to make sense in the big picture, they exist only as simple explanations that can be disproven to justify more complex ones. The Earth is flat has a lot of issues as a theory, e.g. what happens at the edge and how the objects in the sky work, but it is largely consistent with ordinary daily experience.

EMH states that stock prices reflect all available information at any given point in time. Stock prices instantly change to reflect new information as it arrives and those changes will by definition be unpredictable and random, because anything that could have been anticipated would have already been baked into the previous price. As a result, you cannot make money picking stocks.

It’s not clear that when EMH was born any serious researcher believed it as a theory of how the real world worked. It was thought up as a straw man against which it could be proved that you could indeed make money picking stocks, particularly with some “technical” and “chartist” theories that were then popular and, with the advent of computers, could for the first time be tested methodically.

But when the professors used the computers to look at the data, EMH turned out to be very very hard to defeat with statistical significance. In fact, it would be decades before it would be done conclusively.

This simple empirical observation, that stock prices appear to be unpredictable and random and that it is (almost) impossible to demonstrate any way in which they are not random, had far-reaching and profound implications. The most important one with regard to our understanding of finance is that you can model the movement of stock prices as if they were random walks. Just about all the useful stuff to come out of 20th Century financial theory was based on this trick, including our understanding of how to diversify portfolios and value options and other derivatives.

But as useful as EMH is as an assumption, it is lousy as a grand theory of how the stock market, or other financial markets, work. Like the Flat Earth Theory, it collapses in on itself if you think about it too carefully. Any explanation of how EMH could be true has to start with lots of clever stock traders that collectively find the perfect, all information reflected, true price. As new information arrives, those traders instantly move the price appropriately. And how does that dynamic work? How do those traders wind up with the right price? There must be an economic reward given to the smart traders for getting the price right and a penalty for getting it wrong. In other words, it must be that some traders make money picking stocks, which violates EMH.

So even though they may appear to be random, for some traders some of the time, stock price movements are not actually random but are at least mildly predictable. To use a possibly strained sports analogy, the flurry of gestures the catcher makes tells the pitcher what to throw, but are presumably meaningless to the runner on second. To the runner, even though he knows the signals are meaningful to the pitcher, they can best be considered random noise.

Thoughtful people who understand the stock market don’t say that it can’t be beaten, they say it is very hard. So hard, in fact, that it is unwise for all but a few to even try. This got simplified by less thoughtful people as a belief that the market was perfectly efficient and that all market outperformance, even by Warren Buffet, was due to random chance.

The difference between stock price movements being actually random and might-as-well-be random may seem academic, but is not. Firstly, the arguments made by advocates of stock picking against the Efficient Market Theory should impress no one. Just because it makes no sense that beating the market is fundamentally impossible, it is not true that anybody can beat the market.

Secondly, while the evidence around EMH makes a good argument that an individual investor should not expect to successfully pick stocks, it does not follow that there do not exist professionals who can beat the market. Arguing, as many do, that investing in an active fund is pointless because all fund managers are the equivalent of monkeys throwing darts is specious. (On the other hand, the analogous argument that an individual investor is unlikely to be able to separate the monkeys from the geniuses, i.e. that picking mutual funds is no easier than picking stocks, has more than a little merit.)

And finally, it is worth observing that for many advocates of passive investing, their belief in the efficiency of markets is (appropriately) shallow and limited. It is quite common, for example, and I think John Bogle subscribes to this, to believe in equity index funds but to advocate very large allocations to equity as an asset class, in some cases approaching 100%. This is not consistent with a belief in efficient financial markets.

Allocating most of your money to stocks is itself an active decision that only makes sense if you believe that stocks as an asset class are cheaper than they should be. If you thought the markets were perfect then you would assume that all asset classes, stocks, bonds, real estate, gold, etc., were priced such that on a risk-adjusted basis they all had the same expected future return. Putting all or nearly all of your money in one class would then make no more sense than putting it all into a single stock. You would get no improvement in risk-adjusted expected return, since that is impossible, but would greatly increase the risk you were taking on.

That’s not an unreasonable argument, and one that is perfectly consistent with Efficient Market Theory as I understand it. And yet I’ve never heard it anywhere. Is it possible that this great and sinister theory isn’t quite as widespread as its detractors claim?