Do efficient stock markets make you feel small? A group of academicians as well as practitioners believe that stock markets have their own mind and know how to beat you, no matter what strategy you choose. But how could that be? We have come across many individuals who, like Warren Buffett, have made fortunes by constantly running ahead of the market. Let’s examine the intense debate surrounding what is known as efficient market hypothesis.
Illustration: Jayachandran / Mint
Jinny: Hi, Johnny! What’s the matter? Why are you clinching your fist today?
Johnny: Well, whenever I am in a debating mood I clinch my fist.
Jinny: May I know what’s put you in such a debating mood?
Johnny: Recently, I heard about the efficient market hypothesis which believes that an individual investor, no matter how smart he is, can’t beat the market. I have known countless number of individuals who have shown how to make fortunes by their sheer skill of thinking ahead of the market.
Jinny: Well, you seem to be in a debating mood because every hypothesis generates energy for an equally good but opposite hypothesis. But before debating, let’s first understand what the efficient market hypothesis talks about.
The hypothesis evolved during the 1960s and 1970s through the work of many thinkers such as Eugene Fama, Burton G. Malkiel, et al. These thinkers believe that in efficient markets, large numbers of rational investors constantly compete with each other to find out the right price of securities on the basis of available information. So, at any given point in time the prices of securities truly reflect all available information in the market.
In other words, the market is so efficient that any information worth a penny is instantly absorbed by the collective mind of the market and helps in correctly pricing securities.
No one can earn high returns only because he knows better. You can expect to get high returns only when you make riskier investments. A buyer of the security buys at a price that reflects the collective judgement of the market on available information. So you don’t have any scope for picking any treasure lying unnoticed. Likewise, a seller sells at a price that truly incorporates the available information. So efficient markets would not let you sell your garbage at the price of gold. Everybody knows the true worth of what you are holding in your hands.
Johnny: Everybody knows the true worth of every security available in the market? That’s fantastic. Can I know where to find such a market?
Jinny: Well, you may not be able to find perfectly efficient markets in reality. The efficient market theorists put markets into three categories on the basis of quality of information available in the market.
In the weak form of efficient markets, the prices of securities reflect only past information. Finding such a market is not a tough job. Even the laziest markets know how to digest stale news. However, in the semi-strong markets, the prices reflect all public information. Markets, like a hungry shark, gulp whatever current news is floating around. Finally, in the strongest form of efficient markets, the prices fully reflect all public as well as private information. In other words, in strong efficient markets, there is no scope for insider trading.
Johnny: What conclusions can we draw from the efficient market hypothesis?
Jinny: In efficient markets, prices of securities are not predictable but follow a random path. Why so? This is because the events that shape our lives seem to occur in a random manner. The fall of Bear Stearns Companies Inc., Lehman Brothers Holdings Inc. or Merrill Lynch and Co., for instance. Random news creates random movements in the stock market prices. Since you can’t predict random news in advance, it is difficult to predict prices. So, what’s the conclusion? The investor who outperforms the market does so by luck and not by skill. Efficient market theorists believe that neither technical analysis — which is basically an analysis of past trends of prices—nor fundamental analysis, which involves analysis of financial information such as earnings, asset value and so on — can help in discovering undervalued companies.
Malkiel once famously said that a blindfolded chimpanzee throwing darts at The Wall Street Journal could select a portfolio that would do as well as any financial analyst’s.
Johnny: That sounds pretty offensive. What do non-conformists have to say about efficient market hypothesis?
Jinny: Well, the critics use different logic. First of all, information on which the markets move is not freely available. Market sharks have to work hard to obtain the information. The person obtaining the information is the first to benefit from it. Ironically, if everybody believed that the market is efficient and would take care of the flow of information, then the market would not remain efficient because nobody would bother to find new information. In other words, we require people who do not believe in the efficiency of markets to make the market efficient.
Johnny: Thanks, Jinny, for telling me all this. Efficient markets are in fact born out of the seed of inefficiency.
What: The efficient market hypothesis believes that the prices of securities truly reflect all available information in the market.
How: Investors constantly compete with each other to find out the right price of securities on the basis of available information.
Why: In efficient markets, the prices of securities move randomly because of random market events.
Also Read Shailaja and Manoj K Singh’s earlier columns, www.livemint.com/realsimple
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org