Market Deficiency
In a recent Washington Post article, On Wall Street, the Price Isn’t Right, Roger Lowenstein provides a very effusive review of a book by Justin Fox titled The Myth of the Rational Market. In the article, Roger Lowenstein points out how this book will finally put an end to the failed financial concept of Efficient Markets.
He states that Efficient Markets posits that: “… stock and bond markets are nearly perfect …” In my opinion Roger Lowenstein sets up a straw man argument. There are actually many forms of market efficiency which he could have pointed out in the article by simply directing his readers to general investment websites such as Investopedia. See the following explanation on the different types of Market Efficiency from Investopdedia.
1. Strong efficiency - This is the strongest version, which states that all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor an advantage.
2. Semi-strong efficiency - This form of EMH implies that all public information is calculated into a stock’s current share price. Neither fundamental nor technical analysis can be used to achieve superior gains.
3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in today’s stock price. Therefore, technical analysis cannot be used to predict and beat a market.
It comes as no surprise to any one that markets do not perfectly reflect the true price of a company. Are prices 70%, 80%, 90% accurate? This is up for academic debate. The right answer is “for the most part.”
The important takeaway for investors is that the markets do a better job of incorporating new information than an individual investor’s attempt to expose these inefficiencies. Although the book, The Myth of the Rational Market, rails against the mistake of Market Efficiency, it finds little evidence of success among professional money managers in exploiting the inefficiencies its author, Justin Fox, believes are so clearly evident.
He has some kind words for academics who have set up money management firms to apply research on behavioral biases to generate superior returns, but he cites no evidence of their success, perhaps because their results are generally well explained by the standard asset pricing models he is so quick to condemn.
Fox appears frustrated that the evidence of market irrationality appears so clear but the evidence of investor success in exploiting these mistakes is so thin. His brief message to investors toward the end of the book carries an air of resignation-all the effort devoted to identifying flaws in the rational market model doesn’t appear to offer hope of a superior approach. Almost as an afterthought, his practical advice to investors includes the following suggestions:
• “If you have money to invest, the only sensible place to start is with the assumption that the market is smarter than you are. You don’t have to stop there. But if you do come up with an idea for beating the market, you need a model that explains why everybody else isn’t already doing the same thing you are.”
• “If you’re picking somebody else to manage your money, the chances of finding a market-beating path are even harder.”
Bottom line: Market Efficiency should not imply in my view that assets are perfectly priced. No reasoned academic would state as much. But what efficiency does imply is that one individual will not consistently (beyond what can be determined by chance) outperform another investor in pricing the market risk.
And this is what is shown with great regularity in the scientific literature. I have pointed this out throughout this blog. See entries on Active Manager performance and Hedge Funds.
Loading...