Efficient Market Hypothesis

Before we start with the Efficient Market Hypothesis, we need to understand a couple of concepts. Even though you may know of these very elementary concepts they bear repeating since these concepts have to be ‘seared in’. In other words,  they are extremely important. 

Difference between Investment and Speculation

“All investment is, is laying out some money now to get more money back in the future. Now, there’s two ways of looking at the getting the money back. One is from what the asset itself will produce. That’s investment. One is from what somebody else will pay you for it later on, irrespective of what the asset produces, and I call that speculation. So, if you are looking to the asset itself, you don’t care about the quote because the asset is going to produce the money for you.” –Warren Buffett

To be clear, there is nothing wrong with speculation. Just don’t fool yourself that you’re investing when your actions and psyche clearly show that what you are doing is speculating. Speculation is not a bad word, but when you speculate, the rules of the game are different than when you invest. Please don’t confuse the two.

What is Benchmarking?

In the investing world, like in our life we benchmark to some standard that is used as means of measurement. Benchmarking is the process of comparing ones performance to that of the industry in which one operates. A benchmark is the standard by which everyone is measured.

The excess return of the fund relative to the return of the benchmark index is a fund’s alpha. Simply stated, alpha represents the value that a portfolio manager adds to or subtracts from a fund’s return. Investors’ alpha is the value a retail investor adds to or subtracts from the alpha delivered by the portfolio manager. The return of the respective index is considered to be zero alpha, so any excess over the index is considered positive investor alpha.

Behaviour Gap

In the investing business, benchmarking takes the form of comparing our returns with that of the benchmark which is the Nifty 50 or the Sensex as the case may be. Lets just assume that we benchmark our returns to that of the the Nifty 50. In a particular calendar year if the returns from the Nifty 50 are 10 percent and we earn 8 percent, we have underperformed our benchmark. If instead our returns are 12 percent we have outperformed our benchmark. This outperformance is called Alpha. In reality, most of us end up underperforming our stated benchmark because of our behaviour. And this gap is known as the Behaviour Gap. In other words, the Behaviour Gap is the difference between Investor returns and Investment returns.

Behaviour Gap
Behaviour Gap

Why should there be a gap between the investor returns and the investment returns?

Since we want to generate Alpha, we are continuously trying to optimise our investment process and we keep searching for the investment that will give us the highest returns; it may be a stock, a commodity like gold or a hard asset like land. We are all searching for the best possible investment. Hence, we read magazines, research reports and various other sources to find the investment that will give returns that are better than average. What actually happens when we search for an investment? We find one, then we meet someone who tells us that he has a better idea so we sell what we have bought and buy the new idea. And this behaviour gets repeated several times over our investing lifetime. What if, the investment that we sold turns out to be superior to the one that we replaced it with? It affects our overall returns. As a result, we end up doing worse than the average investment.

Another reason why there is likely to be a gap between investment returns and investor returns is because of fees. Since the returns from an investment before fees are higher than those after fees, there is a gap. As a result, investor returns tend to be below the investment returns and this Gap is called the Behaviour Gap.

A lot of research has been done to try and quantify the Behaviour Gap as an actual number or percentage. Various studies have estimated the Behaviour Gap and the results vary as shown in the image above. However, the fact that the Behaviour Gap exists is undeniable.

To summarise as investors we want to:

  • Buy Low and Sell High or vice versa
  • Reduce the Behaviour Gap
  • Generate Behavioural Alpha

What is Market Capitalisation?

The market capitalisation of a business is the total value of what that business is worth as on a particular date. It is derived by multiplying the number of shares issued with the current market price. There is a distinction between ‘free float’ and ‘full’ market capitalisation, but its not important for the time being. If Reliance is trading at Rs. 1100 and the market capitalisation is 700,000 crores it means that the entire business of Reliance Industries can be bought outright for Rs. 700,000 crores. In other words, if one of you were to pay this amount you will be the new owner of Reliance. The question is – is this the fair value for the business? Since stock prices are so important, it follows that the information that they convey must be accurate. To summarise:

  • Stock prices are important since they convey a lot of information. Moreover, market capitalisation which is derived from stock prices represents ownership stakes in the businesses.
  • It follows that prices at which these securities or stocks trade should fully reflect all available information about the business that they represent.
  • The question is: are stock prices lying and if they are how often are they lying?

The question is are stock prices accurate? When Maruti was quoting at Rs. 9600 in January 2018, can we say that it was an accurate price? Or was Rs. 6600 which was the price of Maruti in November 2018 the correct price? Is Maruti undervalued, overvalued or fairly valued? In other words, are the prices that we stare at accurate, or are they lying. What changed from February 2018 to October 2018 that the price corrected so severely? Nothing except sentiment, it turned over from extremely bullish to mildly bearish. The debate over this question has been extensive (it continues to this day, as we speak), and forms the basis for the Efficient Market Hypothesis.

What is the Efficient Market Hypothesis?

The primary role of the capital market is to allocate ownership of an economy’s capital. Once the capital generated is properly allocated to different assets, the stock exchange platform provides liquidity to these assets. An ideal market is one in which entrepreneurs can take capital allocation decisions and investors can chose among the securities present for allocation of capital.

In 1970 Eugene Fama published the paper that is today known as the Efficient Market Hypothesis. What is a hypothesis?

A hypothesis is defined as an assumption made in order to test its logical or empirical consequences. The only way to test a Hypothesis is to look for all the information that disagrees with it.

What did Fama say about market efficiency and prices that came to be known as Efficient Market Hypothesis? He said the following:

  • Fama defined a market to be informationally efficient if the stock prices at each moment incorporate all available information about future values.
  • The informational efficiency flows from the competitive nature of the markets. This part has become very true today, where the cost of obtaining the information is basically zero. In other words, since information is disseminated in real-time and is mostly free, information per se does not confer an ‘edge’.
  • When Fama said that prices are informationally efficient what he meant was that at any given point in time, prices reflect available information. It follows that since the information keeps changing, markets are and will forever be unpredictable.
  • According to Fama, trading rules, technical analysis, market newsletters and all the available tools have essentially no power beyond that of luck in forecasting stock prices.

Criticisms of EMH

The active stock pickers who criticise the efficient market hypothesis argue that

  • The active stock pickers argue that the market only reflects the irrational investor desires. This they argue is done very efficiently by the markets.
  • The active managers effectively believe that investor biases lead to mispricing. The biases lead to the wrong price earning multiples. This results in stocks quoting too high or too low. So good and bad news is extrapolated in an irrational manner with the result that the price earning ratios get skewed. These biases also result in abnormal price variations on both good and bad news.
  • The best definition of market inefficiency is offered by Seth Klarman who says that: “Markets are inefficient because of human nature – innate, deep-rooted, and permanent. People do not consciously choose to invest according to their emotions-they simply cannot help it”. He says that market efficiency is an academic theory and is unlikely to bear any resemblance to the real world of investing.
  • Price is a liar.

How has EMH evolved?

What the Efficient Market Hypothesis did was to bring a scientific method to the study of financial markets. It is because of the Efficient Market Hypothesis that a lot research then began to be done about the manner in which price discovery takes place in the stock market. And today there is a ton of research on the anomalies in investing process and how we can take advantage of them. There is a lot of confusion about what Fama said and he has been criticised by those who haven’t understood exactly what he was saying. As a result, the Efficient Market Hypothesis has continued to evolve and as on date there is a consensus on the following:

  • Stock prices are unpredictable and there is no accurate way in which we can predict the future course which prices will take. In other words, stock prices are random in nature and there is no reason to believe that this will change in the near future. Basically, that is what Fama was saying.
  • Over the long-term, stock prices are efficient but in the short-term, they are not. Hence, the frequent crashes that we see in the stock market all get resolved over the long-term. That is what Benjamin Graham meant when he said that ‘over the short-term, a stock market is a voting machine (it ranks stocks according to those which are currently popular and unpopular). But over the long-term, it is a weighing machine (the market assesses the business of the company)’.
  • The legendary Ben Graham was asked this question about Wall Street professionals: Are Wall Street professionals accurate in their forecasts of stock market trends? If the answer is no then why is it so? The answer he gave was: ‘Our studies indicate that you have your choice between tossing a coin and taking the consensus of expert opinion, the result is just about the same in each case. The reason for this is that everybody in Wall Street is so smart that their brilliance offsets each other, and whatever they know is reflected in the stock prices. What happens in the future is what they don’t know.’This it seems is proof that he was, in fact, saying what Eugene Fama said many years later.
  • As on date, there is a consensus about one thing and that is: (a) Markets are efficient most of the time, but not all the time and (b) Over the short-term, markets are inefficient but over the long-term, they get it right. And to clarify further, the short-term would be anything up to to 12 months and the long-term would be any period exceeding 12 months.


Burton Malkiel’s Random Walk Theory

Burton G Malkiel in his seminal book A Random Walk Down Wall Street – The Time-Tested Strategy for Successful Investing has famously written:

A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one selected by experts.

The phenomenal popularity of the book ensured that the ‘dart-throwing chimpanzee’ became famous in the investing world. Many in the investing world argued that Malkiel may have given too little credit to monkeys!

The Chaos Theory

In 1972 that American meteorologist Edward Lorenz wrote a paper titled Predictability: Does the Flap of a Butterfly’s Wings in Brazil Set Off a Tornado in Texas?. It inspired the ‘Chaos Theory’, also known as the ‘Butterfly Effect’. This four-minute YouTube video explains the Chaos Theory:

The point is that we don’t know the cause and effect and causation is not correlation because human nature is inherently unpredictable.

Benjamin Graham on Mr. Market

To summarise:

Mr. Market is often identified as having human behavioural manic-depressive characteristics, which can be summarised as follows:

  • Is emotional, euphoric, moody
  • Is often irrational
  • Offers that transactions are strictly at your option
  • Is there to serve you, not to guide you.
  • Is in the short run a voting machine. In the long run, the market a weighing machine.
  • Will offer you a chance to buy low, and sell high.
  • Is frequently efficient…but not always. The level of efficiency of Mr Market is increasing with each passing day.
  • This behaviour of Mr Market allows the investor to wait until Mr Market is in a ‘pessimistic mood’ and offers a low sale price. The investor has the option to buy at that low price. Therefore patience is such an important virtue when dealing with Mr Market.

George Soros & The Theory of Reflexivity

George Soros is a very famous and successful hedge fund manager and he propounded the Theory of Reflexivity.

What I’ve tried to do in this lesson is to give you a perspective of the secondary market in stocks. The debate on whether or not markets are efficient has been an ongoing one. And it is likely to remain unresolved in the foreseeable future. In my opinion, it is safe to conclude that markets are efficient over the long-term. Over the short-term, markets are noisy and inefficient.

So What?

What is the whole point of studying the Efficient Market Hypothesis and how does it matter? All of us are trying to maximise returns from our investments. Now just suppose, we invest in an asset that produces a return of 7 per cent. Your friend, neighbour colleague invests at the same time as you do, but he manages to earn a return of 15 per cent. Another person staying in your building manages to earn a return of 10 per cent. As you collate the returns of different investors you find that the average return on investment in the given year is about 12 per cent.  In the pecking order of things and the way the human mind works, the guy who earns 7 per cent on his hard earned money isn’t going to be feeling very happy about his returns. In other words, we want to earn the average returns that the market has to offer. So what do we do? We park our funds with a money manager or we invest in a Mutual Fund Scheme and expect to earn more than the average return. What the Efficient Market Hypothesis says is that over the long-term, the layman investor is better off investing in an Index fund, than an active fund. The reason is that over the long-term, the market is efficient and it is impossible for any money manager to consistently beat the Index (which represents the average return). What Fama was saying and he has proved to be correct is that as an investment avenue, Index investing is the only efficient form of investing. In India we can take advantage of the wisdom of Fama and the others mentiuoned above by investign in an Index Fund.