03 Oct Are markets efficient?
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One of the most hotly debated questions in finance is whether markets are efficient at setting the correct prices for assets. The implications of the answer are profound for investors because if they are not, then there must be significant opportunities for value to be added by identifying those which are mispriced by the market and exploiting that to generate profits. The question arises every time there is large market fall as well as when there is a perceived big risk on the horizon, such as now with the continued uncertainty over the UK’s future relationship with the European Union.
In the wake of the 2007-08 global financial crisis, even Her Majesty the Queen asked British economists how none of them spotted it coming. Their response was that a ‘collective failure of imagination’ among their profession had occurred. However, is it really fair to blame the economists who posited the theory of market efficiency for such events? Is it akin to blaming geologists for earthquakes and volcanic eruptions, oceanographers for freak waves or astronomers for solar flares?
The efficient markets hypothesis was developed in the 1960s and at its core is the idea that in an efficient market, the prices of securities (shares, bonds and the like) will reflect all the information that is publicly available. Obviously the available information is continuously changing as the flow of news is continuous. When relevant news appears, investors collectively adjust their expectations and make decisions to buy or sell on the basis of it, which causes prices to move accordingly. These adjustments happen very quickly (so basing decisions on what you read in the morning newspaper or see on the evening news is unlikely to be effective).
Of course investors, given that they are human beings (or in some cases computers programmed by human beings) make decisions based on their expectations for the future given the information that they have and they are prone to all the biases that the behavioural finance community has identified. Sometimes they overreact, as we see every time there is a major market fall. In such circumstances, liquidating as much as possible can appear to be a rational response for many – if you think the economy is about to blow up, who wants to be owning shares in worthless businesses?
Such a scenario is, according to Professor Gene Fama, entirely in line with the concept that markets are an efficient mechanism for setting prices. Fama is widely regarded as the father of the efficient markets hypothesis and indeed won a Nobel Prize for his work in 2013. Interviewed in 2009, he said,
“The market can only know what is knowable. It can’t resolve uncertainties that are unresolvable. So when there is a large amount of economic uncertainty out there, there’s going to be a large amount of volatility in prices. And that’s what we’ve been through. As far as I’m concerned, that’s exactly what you’d expect an efficient market to look like .”
If this is true, then unless an investor has access to inside information (the use of which, in developed markets, tends to be a criminal offence) or is blessed with the ability to foresee the future, it will be very hard to outperform such a market. On the occasions when they do, this is more likely to be the result of good luck rather than exceptional skill.
One of the challenges to market efficiency has come from the behavioural finance school, which holds that markets make errors in valuation because their participants are irrational and therefore overreact; thus they become greedy in good times and overbuy and then panic in bad ones and oversell.
We could observe this during the global financial crisis, when there was a concern that the entire financial system was close to collapse. However, as it turned out, action by the central banks managed to stave off such an outcome and things weren’t as bad as they seemed at one time. When that became apparent, investors regained some of their appetite for risk and were willing to invest again. This seems inherently logical when looking at the way in which prices fluctuate yet even the behavioural adherents concur on the essential point for real world investors.
This is that even though markets overreact and therefore there is a possibility that prices may be ‘wrong’ at various points in time, the difficulty of knowing whether they are right or wrong makes it pointless to try to second guess the market in the hope of beating it through your superior insight.
Indeed Professor Richard Thaler, a behavioural school supporter, suggested that the 2007/08 crisis had actually strengthened the efficient markets hypothesis because, “While markets could make mistakes, it was still impossible to profit from how they were wrong.”
This is the important point for an investor as opposed to an academic working with models. Even though there are anomalies and unanswered questions around the idea of efficient markets, such as the momentum effect and the way prices move around earnings announcements, making any money out of them requires a large amount of trading and the frictional cost of that tends to overcome any theoretical gain from price movements. Models, as Fama admits, are simplifications of the world and not perfect but for real investors trying to achieve a return on their portfolio to meet their lifetime goals, always holding a diversified portfolio and exercising discipline with regard to trading and costs, the model is arguably good enough to provide a foundation for success.
It’s just not necessary for markets to be entirely and explicably efficient. It is so hard to identify reliably where there are inefficiencies and, most importantly for the investor, to make money from them on a consistent enough basis to make it not worthwhile trying.