Efficient Market Hypothesis: Is The Stock Market Efficient?

As long as humans participate in trading, the markets will never be efficient.

EMH Tenets and Problems with EMH

The EMH is the theory that all new information is reflected instantaneously in the stocks price. This implies that there is no way you could outperform the market by buying low and selling high. Under the EMH, the only reason stock prices should move is because new information has come out. Then, after everyone receives the information and reacts identically, the price will move to its true value.

“If this theory were to be true, then how do you explain the returns of a fund like the Medallion fund, which has yielded over 35% annualized returns over the past 20 years.”

The true value of a stock is the sum of its discounted expected future cash flows. If this is true, we should all come up with the same valuations when looking at a company, and take the same action (buy or sell) until the price is at our valuation (the true value). This theory is misleading in the sense that humans are not rational decision makers; information is not received and acted upon simultaneously; and human behavior has an effect on how we invest. As long as humans participate it trading, the markets will never be efficient.

If this theory were to be true, then how do you explain the returns of a fund like the Medallion fund, which has yielded over 35% annualized returns over the past 20 years. Or Peter Lynch’s fund, the Magellan Fund, which yielded annualized returns of 29.2% for 13 years in a row, consistently more than doubling the S&P 500. The list goes on and on.

And If stocks are accurately priced and reflect all available info, then historic data would be useless. But if that were the case, selling data would not have become a multi-billion dollar industry. If you cannot beat the market then why are these funds and people consistently able to do it?

They are able to consistently outperform the market because they have access to more data than the average investor, they are way quicker to trade and react to information, and their genetic wiring allows their emotions to not get in the way with investing decisions.

People are irrational on many levels, and often buy when prices are too high and sell when prices are too low. Losing a dollar yields more unhappiness then gaining a dollar, when they should be indifferent. People will invest in lottery tickets when the jackpot gets higher because of the imagination of winning the prize yields happiness. Millions of us do this even though the odds are 1 to 175 million.

“They are able to consistently outperform the market because they have access to more data than the average investor, they are way quicker to trade and react to information, and their genetic wiring allows their emotions to not get in the way with investing decisions. ”

Not only are people irrational, but people also have different investment goals and time horizons, which affects the timing of when they buy or sell. This investment decision usually has nothing to do with new news, rather its because of the situation in ones life. Shares could be sold because one may simply be retiring and decides to sell their pension fund. Because Investors hold stocks for different reasons, and have different goals, it is wrong to say that all stock prices reflect the intrinsic value of a company.

The EMH states that we all react simultaneously to any news, but with a majority of trading being done by quant computers, the average investor will buy at prices too high, and sell at prices too low because they will never be fast enough to compete. This will decrease returns from average investors while giving them a higher risk as well.

Under the EMH, corporate managers should only being concerned about increasing their cash flows, which ultimately increase market value (stock price) and shareholders returns. Although managers seem to focus more on earnings growth than cash flow growth. A manager may deny a project that has positive cash flows (positive NPV) if it will decrease their earnings growth. This leads to an inefficacy in a company’s performance. Investors are expecting something that may not be in the manager’s best interest. This leads to more mistakes when analyst predicts the future cash flows and misjudgments of risk when accessing investments.

“A manager may deny a project that has positive cash flows (positive NPV) if it will decrease their earnings growth. This leads to an inefficacy in a company’s performance.”

It is pretty safe to say the market is inefficient. In order for the market to become more efficient there would have to be a universal access to the same high-speed systems, a universal way to analyze the pricing of stocks, and most importantly, the absolute absence of human emotion.

Published by: Charles Mussallem