Long Live the Inefficient Markets Hypothesis.

Every finance class in every business school discusses the efficient markets hypothesis (EMH) in some depth. The theory introduced by Eugene Fama sought to show how financial markets and their rational participants process information efficiently and that above average returns cannot be made consistently. Visit any popular investment site with comments enabled and you will quickly see these so called rational disseminators of information acting ‘efficiently’.

In their most stringent form, Fama’s theories imply that the market has already incorporated all available public and private information about possible future price movements and that any further movement in price is completely random and unpredictable. True practitioners of the EMH believe there can be no early warning signals (because the price would already incorporate it) and so help to build up market bubbles based on the belief that there is absolutely nothing that can be done. Some people blame Fama’s theories for contributing to the 2007/2008 meltdown[1].

The EMH theory gained significant traction and arguably proved itself wrong in the process. We are currently experiencing a generation of indexation of nearly epidemic proportion. Several papers citing that the average fund does not outperform the market in the long run have led to huge inflows of funds into passively managed ETFs. These papers add weight to the EMH practitioner’s argument[2], further igniting substantial ETF inflows.

Total ETF Inflows

Source: http://www.icifactbook.org/fb_ch3.html

No sign of deceleration in 2014 as the number is reported to be over $1.8 trillion and its only July. If the money were to make a speedy exodus away from ETFs where would it go? Can it really be said that it would be dispersed completely efficiently taking into account all public and private information? Despite good intentions, this massive flow of funds all moving in one direction ends up creating market inefficiencies. ETFs leave orphans in their wake as they track sectors and indices where some companies are just slightly too small or not quite a fit.

Another classic example of business school gobbledygook is that of beta, one of the building blocks of the Capital Asset Pricing Model (CAPM) as well as a common determinant of an individual stocks level of riskiness. But I’m not here to argue the valuation technique; I use it regularly, even if only because it is the least dull tool in the box. I only bring it up to show that sometimes a theory doesn’t hold water when you think about it simply. This example is from the legendary investor Warren Buffett:

“The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million. […] Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.”[3]

Can you? What Warren is alluding to is a market inefficiency created by risk aversion, or possibly inefficiency due to a misunderstanding of beta. Many people given a 50/50 probability to either lose $100 or win $110 will refuse the bet[4]. Risk aversion is just one part of behavioral psychology that impacts the market and plays a role in determining stock prices. Behavioral psychology governs market sentiment which appears to be a leading indicator of market irrationality. A rational mind may presume that inefficiency follows irrationality.

The problem about the EMH is that it requires market participants to be rational about the one thing that humans cannot be rational about, money. We have a psychological disposition that makes it difficult for us to make rational financial decisions, especially those including loss or the potential for loss. Aversion to risk is widely documented, and the VIX shows just how much people are willing to pay to avoid risk. In fact, one of the largest unexplained mysteries of the stock market owes its apparent mysticism to risk aversion. Equity risk premium (ERP) is supposed to be the excess return investors require for holding risky stocks. But an unexplained inefficiency occurred when researchers noticed that the ERP was too high and that some of the premium should have been removed by arbitragers[5]. One plausible explanation for this ‘puzzle’ is the existence of widespread risk aversion.

So where does all this inefficiency, irrationality, and misunderstanding of fundamental finance concepts leave us? Celebrating I hope! Inefficiency means there is room for savvy active managers to outmaneuver their competition. As a bottom-up investor it means I’m not wasting my time and as a value investor it means there are truly neglected and undervalued investments waiting to be discovered. I say, long live the inefficient markets hypothesis.

[1]Fox, Justin (2009). Myth of the Rational Market. Harper Business.

[2]They also add fuel to my fire as, in my opinion; they study a flawed argument in the first place. The stock market past the market return is essentially a zero-sum game. All market participants fight for gains above the average total return (which is what a broad index should generate) at the expense of market losers. So the average active fund is fighting institutional investors and individual investors to produce an above average market return. Because of the added costs of actively managing money it is an uphill battle and so, not surprisingly many managers fall below a passively managed benchmark. But, the great investors of our time have proven that they are not average money managers. If you don’t believe me read about the protégés of Benjamin Graham and view their 50+ years of results. These above average investors are winning from below average investors. Graham’s protégés have probably caused several thousand fund managers to underperform in the last half century.

[3]Buffett, Warren (2004). “The Superinvestors of Graham-and-Doddsville”. Hermes: the Columbia Business School Magazine: 4–15.

[4] Rabin, Matthew. 2000. “Risk Aversion and Expected-Utility Theory: A Calibration Theorem.” Econometrica. 68(5): 1281-1292

[5] Mehra, Rajnish; Edward C. Prescott (1985). “The Equity Premium: A Puzzle” (PDF). Journal of Monetary Economics15 (2): 145–161. doi:10.1016/0304-3932(85)90061-3.

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