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Wednesday, August 29, 2012

What is Market Efficiency?

Can you beat the monkey?
In a large part of my world, there are 3 types of people  -  those who believe it is possible to beat the market, those who don't, and those who don't understand the question.  I have found that it is less challenging to convert the first group to the second group than it is to get a Democrat converted to a Republican and vice versa.

This is a market efficiency question.  Market efficiency implies that prices reflect all publicly available information and, no matter how much you analyze markets and stocks, you are better off indexing the market.  Market efficiency is clearly a counter intuitive notion.  After all, from the delivery room on, we have been preached the virtues of hard work.  Hard work is the key to advancing in the work world, as an athlete, or even with our relationships in life.  How could it be otherwise in this area?  How could it be, in something as complicated as Capital Markets, that hard work doesn't create an edge.  How can it be that very basic, well-diversified portfolios consistently outperform the professionals with all their resources?  How is it that an average Joe Blow, absent a degree in finance from a top ten school who spends less than an hour a month on investments, outperforms the country's biggest pension funds and hedge fund managers?

Market efficiency is a concept that has produced considerable academic and real world research and discussion.  The research has come at the question from different angles.  One broad area focused on specific metrics.  For example, can you produce exceptional returns by investing in stocks as soon as they announce a stock split, a surprisingly good earnings report, a dividend increase, etc.?  If you can think of  a likely candidate, you can assume that it has been studied.  Although this research finds some minor what are called "anomalies" in some instances, they are small and, once real world factors such as commissions are taken into account, not worth exploiting.

In addition to this academic research on specific approaches, the other broad area has been  performance.  To me this is the most valuable.  I say this because I know a little about statistical analysis, regression analysis, etc. and its shortcomings.  But performance is the bottom line.  If really smart people can analyze publicly available information and beat the market, they would blow away the simplified, indexed approach.  Period.  I say this because I have been on the institutional side of the business.  I have met and known brilliant analysts, investment managers, and strategists.  They are smart and have incredible resources at their finger tips.

Frankly, the average person has no idea how smart the group at Long Term Capital Management, the largest hedge fund into the world whose  efforts led to the need for a Federal reserve bailout, was.  They had Nobel Prize-winning economists as advisors along with "quants" from the isk arbitrage group at Salomon Brothers.  The average person has no idea of the resources former guru Bill Miller had at his finger tips before he imploded.  He could pick up the phone and talk directly to many CEOs of the top companies in the U.S.

Not only do the smartest and the brightest underperform - they go down in flames on a regular basis. Somehow, analyzing publicly available information isn't that easy.

To economists, efficiency isn't a foreign notion.  If some one walks in where I am right now and says that he heard a guy opened a lemonade stand down the road and made $10,000 the first day, an economist understands that trying to do the same will be futile.  Those who got into the Beanie Baby craze understand what I'm saying.  In fact, there have been studies examining whether people gain an advantage by changing lines at the grocery store checkout counter.  Other studies have looked at people changing lanes as they traverse the New Jersey turnpike.  Guess what?  When others are trying to do the same, it doesn't pay on average.

So, the bottom line is there is something else going on here as people try to use publicly available information to get ahead in the markets.  Another way to say this is to point out that the brilliant analysis of the talking head on CNBC right now is useless.  To me, this is elementary because the next talking head in line is just as brilliant but with an opposite point of view on markets as well as specific stocks.

But that's what makes a market.
If it is possible to analyze publicly available information and over the long run beat the market, then there would be a lot of investment managers beating the market.  Like seeking a surgeon, the first question we would ask would be for their track record.  Actually, the academics have examined track records and found them to be of no value in predicting future performance.


  1. Thanks for sharing this information. I found it very informative as I have been researching a lot lately on practical matters such as you talk about..

  2. Yea, "research" is pretty useless, is it not? Randomly guessing and picking stocks may even equal or beat the performances of some of these managers.

    1. Actually there is research showing that managers analyzing and picking the best stocks from a list doesn't perform better than picking from the list at random.
      Ignoring the evidence is costly.

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