Sixty years after it was first formulated, the central tenet of the Efficient Markets Hypothesis (EMH), that stock prices fully reflect all available information, still holds true in many areas. regarded as gospel truth. Prices are adjusted before investors can trade on new information.
Assumptions about the market
Another key prerequisite for EMH is investor rationality. This means that investors automatically adjust valuation estimates with each new information. EMH recognizes that individuals can independently deviate from reasonable behavior. However, the third assumption of this theory is that irrationally optimistic investors are just as common as irrationally pessimistic investors, and thus “in a manner consistent with market efficiency. Prices are likely to rise.” corporate finance explanation.
While the argument that such irrationality always cancels out may seem a little too tidy and unrealistic, EMH’s fourth assumption is that irrational amateurs are temporary This means that you will be faced with rational and intuitive experts who take advantage of mispricing.
The fifth basic reasoning is the perfect competition reasoning. No investor can control any segment of the market and extract monopoly profits over the long term.
As a result of the above, there are no patterns in stock price fluctuations and prices always represent true value. Prices follow a random walk, and investors cannot consistently profit from trend following, momentum buying, or any other investment style.
To anyone with experience in the open markets, these axioms — perfect information, investor rationality, mechanisms to offset irrationality, systematic arbitrage, and perfect competition — are, at best, preposterous. But as sociologist Raymond Budon observed, “people often have good reason to believe a questionable or false idea.” One particular belief flagged by Budon is that homo economics as a rational being,almost like god“
What makes EMH so attractive is the premise that the market is the optimal capital allocator and wealth creator. But the supremacy of capitalism over a planned economy does not justify the theory. Here Max Weber’s core research principles apply.A statement of fact and a statement of value are two different things and should not be confused.” This is where EMH went wrong.
Dismantling market efficiency
Let’s see why EMH’s economic interpretation is questionable.
1. Accuracy of information
First of all, the concept of complete information ignores the fact that information is manipulated, inaccurate, misleading, fraudulent, or simply difficult or impossible to understand. doing.
Market rigging is not newCreative accounting and outright fraud are common, especially Between a bubble and a market correctionThe dotcom and telecom mania has caused various scandals. The latest euphoria orchestrated by the central bank’s zero interest rate policy has resulted in excesses such as Wirecard and his FTX.
In the age of fake news and instant messaging, the claim that market prices include all available data does not consider the risks of misrepresentation.
2. Information access
Market prices can reflect complete information only if all investors access the same data at the same time. For example, in the UK One-fifth of public takeovers are preceded by questionable share price movements.. Insider trading is rampant and all the time.
A survey of all acquisitions, mergers and leveraged buyouts in the previous year, conducted in April 1985, found: business week The magazine found that in 72% of cases the stock price rose before the deal was publicly announced. Drexel CEO Fred Joseph said:Urbs [arbitrageurs] Perfected the technology to obtain inside information“
Heterogeneous data access doesn’t just affect stock and bond exchanges. Four years ago, the Bank of England and the US Federal Reserve found that some traders and hedge funds received statements from policymakers. 10 seconds before broadcast.
3. Information processing
Sophisticated investors analyze information in a methodical, rigorous, and rapid manner. Algorithmic tools give institutional investors a solid edge over inexperienced investors.
successful quantitative trading in Jim Simmons Renaissance Technology and other hedge funds have shown that good data analysis can consistently, if not always, help them beat the market.
Mass investor confusion is a real phenomenon.Investors misunderstood Chinese companies zoom technology The former’s stock price soared 70000% in 2019 with the newly listed Zoom Video. A year later, when the world went into lockdown, it happened againThese are indeed isolated anecdotes, but given such a fundamental mistake, is it credible to assume that stock prices accurately reflect all available information?
Beyond Information
The main drawback of EMH is that it provides a narrow definition of market efficiency, focusing only on data availability. This oversimplification fails to acknowledge that the market is more than just a reflection of data flows. Friction can be caused by other factors.
1. Trade execution
Once an investor has accessed, processed, and analyzed information, it must be able to execute transactions seamlessly. Market makers and professional traders may have this ability, but retail investors do not.of Frontline scandal at Robinhoodis just one example of uneven competitive conditions when customer order data is shared with High Frequency Traders (HFTs).
This kind of practice is not new.of the man who solved the marketGregory Zuckerman, explains that in the mid-1990s, “shady traders” were “taking advantage of” Simons’ hard work by “monitoring.” [his fund] trading medallions. Michael Lewis explained how HFT speeds up trade execution. flash boysThey deploy computer-driven trading robots to access private venues called “dark pools” to hide their trades, and physically approach public exchanges to trade before other participants. , paying intermediaries for early access to information, all cleverly maintaining an unfair advantage.
Ultra-fast connections and algorithmic trading should democratize access to stock exchanges, improve liquidity and reduce spreads Do not rig the market by enabling front-running.
2. Pricing
According to EMH, price changes are statistically independent of each other. Occurs when new data appears. There are no trends that investors can identify. Market reactions to new data do not include investor overreactions or delays. Prices always reflect all available information.
Benoit Mandelbrot’s previous EMH research showed that stock prices are characterized by concentration and long-term dependence. New information moved the market, but so did other factors unrelated to momentum and data flow. Investors can profit from trend following, momentum, seasonality, and other strategies.This contradicts EMH and further Study of persistent return anomalies support the conclusion.
As Warren Buffett said in his Coin Toss article: For the Graham and Doddsville super investor, it is possible to consistently beat the market.
3. Investor behavior
Investor rationality is perhaps the weakest of the EMH assumptions.
Behavioral economists have long argued that investors are emotional. Demonstration by Robert Shiller It shows that stock prices are more volatile than would be expected if investors were strictly rational. Investors tend to overreact to unexpected news.
It has always seemed like wishful thinking that the actions of irrational investors are somehow neutralized by arbitrageurs, or by other irrational investors who take the opposite stance. rice field. Lacking speculation in the pricing process is as unsound as theory.When Speculation Can Explain Price Movements Cryptocurrency market or memetic stockswith no underlying cash flow or supporting performance data, why can’t it play a role in broader market activity?
Verification and Tampering
Behaviorists and EMH Advocates Fiercely Debate Market Efficiency. Eugene Fama, one of the pioneers of EMH, admits that the theory cannot be fully tested. “That’s not entirely true,” he said. “There is no perfect model.” Partly for that reason, he Define 3 types of efficiency: A weak form based on historical trends. A semi-powerful form containing all public information. Powerful forms where price movements also contain personal information.
Strong form has long been discredited given the rampant insider trading and instances of market manipulation by sophisticated investors to the detriment of inexperienced speculators.
Neither Mandelbrot’s study nor Buffett’s superinvestors saw semi-strong form as credible. Market prices do not depend solely on information.
Investor rationality is a central assumption behind many economic theories, but philosopher Karl Popper explains it:theory. . . nothing that can be empirically verified.Until proven in a universal and unconditional way, they cannot be considered true, but they can be falsified at any time.
For Popper, the most uncertain theories necessarily tend to be the least susceptible to criticism. The iterative process of tampering and verification is endless and leads to intermediate conclusions. The problem is knowing when enough contradictions have accumulated to cause the theory to be abandoned.
multiple truths
Financial markets are flawed, but the extent of the flaws is not clear. Unless indisputably tampered with, EMH will continue to dominate. Recognizing the weak position of detractors, Fama said:There is no behavioral asset pricing model that can be tested in advance.Of course, the same is true of his own market efficiency model.
Markets can be efficient or inefficient. They can be both at the same time. This is what the proponents of the hybrid version are trying to decide.Andrew Law adaptive market theoryFor example, it blends both aspects of market efficiency and activism.
If they are neither mere information nor full action, it is unlikely that markets are both exclusive. But this does not go against the idea that sheer luck can repeatedly beat the market, like a coin-flipping contest. Have the skills and experience — use algorithms or alternative methods. Or through inside information or other criminal means.
Despite the seeming randomness, there is order in the chaos of financial markets. A major challenge for investors is how to devise an investment style that always, if not always, outperforms.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect those of CFA Institute or the author’s employer.
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Sebastian Candell
