Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.
In the second part of the Harry Potter movie series, namely “Harry Potter and the Chamber of Secrets”, there was a character, named Professor Gilderoy Lockhart, who was advertised as a Polymath, a master of everything, celebrated as the most efficient in all arts of magic. But in the end, he came out to be a fluke.
The reason I mentioned it here is to put up some limelight on the term “Efficiency”. Even Nicolas Léonard Sadi Carnot, the inventor of the infamous Carnot Engine, claimed that nothing can be 100% efficient.
Efficiency, the ability to achieve maximum productivity with minimum wasted effort or expense. Sounds cliche, isn’t it. But in the case of markets, this term evolves to get an uncanny origin. It refers to the coverage of all the relevant information available be speaker by the prices of stocks and securities.
So, are the stocks market efficient, and if they are, how do some people end up making a fortune by meticulous analysis, while some go back home with lesser than they invested ?.
Efficient Market Hypothesis – Too Good to be True!
We traders, in our long history of battle in the war field of the markets, have been continuously bombarded with the sales pitch from experts, claiming to have found out the holy grail model that guarantees investment success. You can have the possession of a low-risk high return portfolio using the secret strategy devised by them.
Although the probability of such strategies being devised isn’t zero, it is impossible that they will always work, considering they take into account an efficient market.
The question of Market’s efficiency plays a critical role in deciding the trading philosophy of a trader. If the markets are in fact, efficient, then a trader would diversify across a broad band of stocks and not trade often. They wouldn’t pick undervalued or overvalued shares and try to time the market.
On the flip side, if you are an atheist to the concept of market efficiency, then your strategy will revolve around putting the ball in your court by exploiting the mistakes made in the markets. But with improper risk management, you might end up in far lower return than your Uncle who invested in an index fund.
As prevalent, it cannot be deducted with utmost security that one will subdue the another. We have to find a sweet spot in between both the philosophies to turn it to our advantage. Moreover, analyzing where and when there are market inefficiencies helps us in the far more prosaic task of picking investment strategies. In addition, market inefficiencies can provide the basis for screening the universe of stocks to come up with a subsample that is more likely to have undervalued stocks.
So is it Completely a Fluke?
Contrary to popular belief, market efficiency does not require that the market price should always be equal to true value. All it requires is that errors in the market price be unbiased. But it also disregards the very basis of making money out of the markets. That is, it follows that no group of investors should be able to consistently find undervalued or overvalued stocks using any investment strategy.
It is extremely unlikely that all markets are efficient to all investors at every tick of the clock. If it had been so, then no group of investors should have been able to consistently beat the market by exploiting its imperfections.
Should the Grace of Efficient Markets be Showered Upon You?
The claims of EMH (Efficient Market Hypothesis) makes it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing. But, considering the words of biggies of this domain, an efficient market is still a hypothesis and not a theoretical concept.
I am not well qualified to criticize the efficient market hypothesis because as a market participant, I considered them so unrealistic that I never bothered to study them.
Assuming an equilibrium in the finance market, EMH completely defies the idea of making wealth via markets. Even after 57 years of its conception, it is still regarded as a hypothesis in most of the books. Researchers usually claim that if EMH would have held true, then most of the traders had been crippled in generating any alpha. Even from a historical point of view, EMH is unable to hold its accountability, because it assumes a state of equilibrium in the market. But we all have witnessed the history otherwise, isn’t it?
Nothing Changes, if Nothing Changes
Market Efficiency turns out to be hypothetical. It might hold true in the same world where evolution never happened and humans are still apes. But contrarily, it is not completely useless. It can provide a financial description of the markets.
Sadly, it is inevident because it does not provide any testable condition of the financial market. So traders, always are geared up, do hardcore research and remember, the power is in you, you just have to invoke it at the right time.
In theory, theory and practice are same, in practice, they are not.