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The Efficient Market: A Hypothesis

The western capitalist societies place an inordinate amount of confidence in the abstract concept of “the market”. We commonly rely on the market to solve our problems, to ensure that our world progresses in the right direction, and to distribute the collective wealth we have created. However, many people fail to understand what a functioning market entails, and the requirements that must be fulfilled for a market to be considered efficient.

The previous article in our Introduction to Investing-series looked at the company, and how they form the basis of what we refer to as “the market”, and how, when looking at it through the lens of investing in the stock market, any given market is made up of a selection of public companies. In this article, we will investigate the economic theory of efficient markets as it relates to the stock markets where we are considering placing our hard earned money.

The Characteristics of An Efficient Market

When we talk about a market being efficient, we are referring to collective of every participating investor’s ability to price companies in a way that accurately reflect the value of said company. Now, you might argue that one person’s idea of what a company is worth can vary wildly from what the next person thinks, and you would be right. In fact, the very idea of an efficient market is that the collective valuation, the sum of all those individual investor’s varying opinions, is the right value. The market aggregate negates the irrationality of the individual investor.

Or, stated as Eugene Fama, the Nobel Prize-winning economist, did when he formulated the hypothesis of an efficient market in 1970: The price of an asset fully reflects all available information of said asset. In other words, Fama states that the market, which is a composite of every participating investor, will digest every single piece of information about a stock, and adjust their valuation accordingly. Information in this case in not just limited to financial reporting such as earnings and similar, but changes to the competitive and regulative landscapes, even all rumours which may affect the company.

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In an efficient market all information is reflected by a company’s stock price.

The stone cold implication of an efficient market is that there is absolutely no reliable way to generate returns more than market growth. This because every piece of information available is, at any given time, reflected by the price of stock. As such, there is no point in trying to predict whether the price of an asset will rise or fall in the future because it is entirely random.

If this sounds familiar, it is because most personal finance bloggers out there espouse the teachings of the efficient market hypothesis. In particular, a direct result of an efficient market is that because of the transaction costs incurred by active portfolio management, placing your money in an index fund is likely to yield superior returns. A recent report has given weight to this claim.

Financial Markets Are Not Efficient

Think about the necessary requirements for a market to be truly efficient. All information would have to be absorbed and acted upon immediately because any lag in adjusting the price according to new information is a market inefficiency. Further, human beings are not rational, even in the aggregate. Studies within the field of behavioural finance have shown that masses overreact to fear in downturns, and become overconfident in good times.

In addition to lag times and irrational decision makers, other issues such as insider trading make efficient markets a theoretical construct, more than a financial law. However, the underlying theories continue to stand strong after 50 years in the limelight, and it is worth having the ideal of an efficient market in the back of our heads as we make our investment decisions. If you want to read a more detailed discussion about the subject, a good place to start is Burton Malkiel’s research paper The Efficient Market Hypothesis and Its Critics. It was published in 2003, but a global recession followed by a near unprecedented bull market later, its discussion points still stand.

How To Invest In A Non-Efficient Market

Having established that the financial markets in which we invest are not efficient, it stands to reason that it is possible to generate returns in excess of what the market as a whole provides. How do we account for this, and can we easily construct our investment portfolios in a way that allows us to capture the excess returns?

The short answer is no. Even in a market with inefficiency, it’s hard to create extra returns. Yes, it is possible to make calculated bets and create excess returns by winning these bets. However, even in a market that is a not perfectly efficient, the return is correlated with risk, and you only “win” or create extra profits by making a bet which is more of a sure thing that the market price indicates. Otherwise, you have flipped a coin and won, which isn’t a sustainable long-term strategy.

Further, even if someone could pick winners more reliably than the market, there is simply no incentive for them to share this information with the public. Think about it, if you knew of a sure thing that other people did not, why would you share this information with the world? You would simply be telling the market to account for your knowledge and thus reducing the size of your jackpot. You can turn on the TV every single day and find people telling you that everyone else is a fraud, but they are the real deal, so you should listen to them and, more importantly, pay them for their secrets. These people don’t know. They have a more or less informed opinion, but if they knew a sure thing, they would not be sharing it with the world or even their employers. Instead, they would put all the money they could accumulate on their sure thing, and collect the proceeds.

A sustainable strategy in an almost efficient market, which is theoretically sound and with a proven track record, is long-term value investing. This strategy can be executed either by investing in broad market index funds or by creating a diversified portfolio. Whether you aim to beat the market or not, you will likely be able to generate significant returns over the long term by adopting a long-term value investing strategy.

The next editions of this article series will look at the principles of portfolio management and detail why index funds are an alternative to doing it yourself. Be sure you don’t miss out by subscribing to our mailing list. You can also follow us on Twitter or Facebook, where we shout out whenever we publish a new post.

Title photo by Ken Teegardin