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Are Markets Efficient?


The Short Answer.


Of course markets are not efficient. A quick glance at all the recent debacles in markets all over the world (Cryptocurrency, Gamestop, Expolanka) will provide enough clear evidence of this. You’re welcome! Now move on with your life, or, if you have time, go grab a cup of tea and read on for a longer analysis of the Efficient Market Hypothesis, its flaws and an adjusted version I believe is more reflective of reality.


The Efficient Market Hypothesis - A Fancy Car for Rush Hour Only.


Finance professors have always liked the idea of efficient markets. Their Efficient Market Hypothesis (EMH) states the following:


  • There is a huge number of sophisticated and motivated market participants with equal access to all relevant information.

  • Because of the collective efforts of these participants, all information is fully reflected in the price of each asset: Participants will immediately move to buy any cheap assets or sell any expensive assets based on information that becomes available.

  • Thus, market prices already reflect the fair value of an asset and no investor can consistently identify and profit from market mispricings.

Based on the above statements, EMH makes the below conclusions:


  1. It is not possible to attempt to beat the market, and any attempt to do so are a waste of time and money.

  2. Anybody who outperforms the market has just got lucky and will revert back to the average performance over time.

  3. Since assets are fairly priced, assets that offer a high return also have high risk, and assets that are low risk offer a low return. Investors can just select based on their risk tolerance and will get a suitably fair return for the risk taken. There is no such thing as a free lunch, where one can get a high return with low risk.


The EMH is useful for academics as it allows them to use concepts such as “risk aversion” and “beta” to try and explain and predict economic behaviour in their model world. However, while most of the models built on EMH work in the short term, and during more calm phases of the market, they tend to fail during the most important periods of high volatility. This essentially makes them quite useless, as most of the risk and opportunity for an investor occurs precisely during these periods of mania or panic. EMH is like having a fancy car for driving during your boring rush hour commute that never works on track days.


The Superinvestors of Graham and Doddsville


The most common evidence based rebuke of the EMH are the celebrated investors we all hear about. Chief among them Warren Buffett, who has generated an astoundingly long track record of consistently beating the market. From 1965 to 2022, Buffett generated a gain of 3,787,464% compared to the S&P 500 index generating 24,708%. In other words, $1,000.00 invested into Buffett's company Berkshire Hathaway would be worth $37,874,641 while $1,000.00 invested into the market would be worth $247,081. While both are staggering numbers that show the power of compound interest in the long term, it is clear to anyone that Buffett has totally dominated the index for a prolonger period, in violation of the conclusions of EMH.


The theoreticians would respond that such exceptions are normal when dealing with such a large sample size of investors. If there are millions of investors, then there will be several “one in a million” investors who show exceptional results through good luck.


I think this good luck argument is very weak. Buffett’s exceptional article “The Superinvestors of Graham and Doddsville” debunks this elegantly. It is a great article, that I recommend reading. You can find it here. (As with any article about Orangutans, the part about Orangutans flipping coins is the most important section).


The Flaws in EMH: Forgetting Humans are Human


“In Theory, there is no difference between theory and practice. In practice, there is” - Yogi Brera


In my view, EMH falls apart primarily on its first premise. Investors are not sophisticated and rational operators, but emotional beings that are prone to behavioural mistakes such as

  • Hallucinating absurdly positive or negative scenarios such as:

    • Every car ever driven will be a Tesla some day.

    • Bitcoin will replace every global currency as a medium of exchange.

  • Groupthink and following the crowd.

  • Doubling down irrationally on losing bets, refusing to take a loss or admit an error.

  • Getting too greedy in bull markets, and putting on too much risk via margin loans which subsequently blow up forcing investors to liquidate even if they don’t want to.

  • Not even looking at a company’s business model, long term outlook and valuation when investing (The horror!).

  • Using short term funds for long term investments, that then need to be sold at a loss when the funds are needed.

In addition to the above behavioural mistakes, there are also other issues with the theory:


  • Information is not distributed perfectly. For instance, in Sri Lanka, most of the marginal price setting retail investors are not even able to read English well, let alone understand accounting concepts well enough to interpret complicated financial statements. For example, LOLC Holdings, a popular retailer stock has an annual report with a whopping 336 pages.

  • There is no universally accepted “theory of how to make money in markets”. Different investors attempt to buy and sell stocks based on different techniques such as technical analysis, value investing, doing what their Uncle Johnson said, growth investing, “gut feel” and even astrology. Not all of these can be correct.

  • Markets with low liquidity experience high volatility and friction, amplifying irrational moves by smaller investors.

All these flaws mean that EMH, does not work in the real world, and its conclusions also need to be adjusted to the real world. We need a model closer to the truth, even if it is messier and harder to use mathematically.


The "Usually Efficient but Sometimes Wildly Crazy Market" Hypothesis


In my opinion, the correct form of this theory consists of the below statements. I call this the “Usually Efficient but Sometimes Wildly Crazy Market" hypothesis.


  • Market prices effectively reflect the consensus interpretation of the publicly available information about an asset.

    • The market is not a weighing machine showing the objective truth, but a voting machine showing what people vote to be the truth, based on their information and perspective.

  • This consensus interpretation is usually consistent with reality, but not always and is prone to periods wild overoptimism or excessive depression along with all the other psychological failings human crowds are susceptible to.

  • How often the market is correct (i.e: the degree of efficiency) can vary depending on its liquidity and the sophistication and psychology of its participants. Some markets like Sri Lanka or cryptocurrency are highly inefficient, while others, such as global foreign exchange or mega cap American equities are highly efficient.

  • While in general markets tend to revert to pricing in the true state of reality, and mistakes get corrected over time, there is no guarantee for when this will happen. There is also no cap to how far from reality a market price diverges before it reverts. As John Keynes said, "The market can be irrational longer than you can remain solvent".


While the above statements do not allow elegant mathematical models (reality rarely does), it does allow a few useful conclusions about how one should behave in financial markets, as explained below.


How to behave in Usually Efficient but Sometimes Wildly Crazy Markets

I believe the below conclusions come naturally from the above characteristics of real world financial markets.


  • The opportunity to outperform the market is rare and outperforming consistently into the long run is hard.

    • As the market prices in the consensus view, you will not generate a good risk adjusted return by just having the same views as the consensus. You need to have a non consensus view that turns out to be correct.

    • Since the market is usually correct, such non consensus views that are actually correct are rare and hard to find.

    • Hence to outperform over the long run, you must regularly find ideas that are different to the consensus, and be more consistently correct than the consensus.

    • This is awfully hard.

  • Due to the rarity of these opportunities, when you do see one, you must move fast and swing hard.

    • As elaborated more here.

  • You should seek to participate more in markets that are more inefficient, where your chance of consistently finding mispricings is higher

    • Such markets typically have unsophisticated participants, with poor capital discipline (i.e: Investing with short term funds and on margin), opaque information and low levels of liquidity.

    • The presence of a lot of mispricings are a double edged sword. While you are likely to find bargains, you are also likely to find highly overvalued low quality investments. Hence randomly picking stocks in such markets could be deadly.

  • You have to be careful with position management to survive irrational markets getting even more irrational as per the above John Keynes quote.

    • For instance, using borrowed funds or shorting stocks reduces your ability to hold through difficult market movements. Many investors correctly called the dot-com bubble, but were not able to survive shorting it or the investor redemptions caused by long periods of underperforming the euphoric markets of the 90s that they correctly avoided.


Conclusion


For me, the main conclusion from all this is that market efficiency is a spectrum. Some markets are highly efficient (but never perfectly efficient as specified by the EMH) while others are highly inefficient. The efficiency of the market also varies depending on the level of uncertainty and crowd state of mind, which varies with time. For instance, even typically rational oil markets totally blew up during covid, with oil futures even going negative.


Prior to participating in a market, it is important to understand where in the spectrum it is and adjust your behaviour based on that. You should stick to index investing in more efficient markets while cautious stock picking can work in more inefficient markets.


Even if markets are inefficient, they should still be respected as generally correct. The prices shown to us by the market should be presumed correct, unless we have compelling evidence that proves otherwise.


I leave you with a popular joke about a professor who believes in EMH:


A professor and his student were walking down a road when they spotted a $20 bill. The professor said “That cannot be a 20 dollar bill. EMH states such free lunches cannot exist as someone else would have picked it up already.” and walks on. Meanwhile, the student picks up the 20 dollar bill and goes and grabs a free lunch.


Note: A lot of the ideas for this article were cloned from Howard Marks, one of my personal investing heroes. I highly recommend his excellent book “The Most Important Thing”.






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