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Markets are efficient. Except when they aren’t

There are risks and opportunities in this contradiction.

Since the 1970s there has been a strong school of thought that markets are always efficient – that the current share price of any company is the most accurate reflection of its value. This is why it is so hard for anybody to outperform the stock market over long periods of time: all of the information about any share is already in the price.

If this were completely true, however, markets would never go through the sort of bubble-and-bust cycle experienced in the dot-com era at the end of the 1990s. The prices being paid for shares in internet-related businesses at the time did not reflect their value, and when the bubble of irrational investor exuberance about these companies burst, a lot of money was lost.

This is a reflection of what behavioural scientists have known for decades – that humans do not always behave rationally, and that large groups of people can act in the same irrational way if they are presented with certain information in the same way.

It’s not so simple

To a large extent, markets are a reflection of these two competing forces:

“To be able to explain how prices work, you need to be able to be able to explain how on the one hand investors appear to be irrational, but on the other hand markets are very hard to beat over the long-term,” notes the president and chief investment officer at Morningstar Investment Management, Daniel Needham.

He argues that to understand this, investors should appreciate that share prices are not a reflection of a single cause and a single effect. Markets are ‘complex, adaptive, systems’, much like what one sees on a busy road.

As Needham explains: “If you are a driver, you make decisions, you influence the traffic. Then you respond to the traffic that you influenced, and then you respond again. These are called interactions. And as the number of drivers increases, and as time increases, the interactions increase exponentially to the point where they are computationally irreducible – you cannot predict the end point.”

How we get to a price

In markets, this does lead to efficiency most of the time due to the wisdom of crowds. This concept was illustrated by the famous jelly bean experiment conducted by Michael Mauboussin in 2007.

Mauboussin filled a jar with 1 116 jelly beans and asked his 73 students at Columbia Business School to guess the number. Their answers differed significantly, from a lowest guess of 250, to a highest of 4 100. The average individual error was 700, which is 60% off.

Yet, despite the inaccuracy of the individual guesses, their average (mean) was 1 151. This was just 3% away from the actual number, and only two students actually guessed closer.

What this shows is that even in situations where information is incomplete, a crowd predicts better than the individuals in it. A range of investors buying and selling a stock will therefore push that stock to an average – and therefore fairly accurate – price.

Yet this can break down …

However, for the wisdom of crowds to work, one very important factor has to be in place: diversity. In the stock market, this means investors operating independently and differently from each other.

Mostly, this is the case. Sometimes, however, it isn’t.

This is because, as humans, we are heavily influenced by the behaviour of others, particularly when we see that behaviour leading to some kind of benefit. This is, after all, how we learn language and appropriate social and cultural behaviour. It is in our nature to imitate what we see as successful.

“In certain environments, imitation is useful,” says Needham. “In others, it’s very dangerous. We think it’s particularly dangerous in markets.”

Where a large majority of investors starts behaving the same way, there is a breakdown in diversity and therefore the wisdom of crowds fails. That is what leads to mispricings, with major bubbles being the most extreme examples.

“Markets are inefficient when people are copying each other – when they are homogeneous, using the same decision rules,” Needham explains.

Where contrarians have an advantage

Markets are always at risk of this behaviour. On a large scale, it is what happened during the tech bubble of the late 1990s, but on a smaller scale it can constantly be seen in the prices of individual stocks or sectors that are either in or out of favour.

When prices are rising and investors are making money, other investors are attracted to that area of the market. When prices are falling, investors retreat.

There is a risk that this leads to investors selling low and buying high, but it also opens up opportunities for others who are willing to be contrarian.

Because if parts of the market are no longer operating efficiently, it means that share prices are not reflecting their true value.

These mispricings can be exploited by those investors who are willing to take the other side of the trade – to buy into falling markets and sell out of those that are overpriced. Theoretically, this might sound simple, but it takes discipline and courage to do it.

“Contrarians benefit from standing apart from the crowd, but there is no free lunch,” says Needham. “There’s a reason why these opportunities exist – because it’s hard to stand against the crowd. As humans we are susceptible to being heavily influenced by others.”

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The discussion about price efficiency is a bit moot, certainly in the context of being able to beat the market. The market may not always be informationally price efficient, but no one can be sure when it is, and when it is not. No one has all the available information, or can be certain they have all the available information.

This means that no one can reliably take advantage of any price inefficiencies when they do happen. Plus there is always new information coming into the market, which may invalidate previous expectations (and which more likely explains the inability of fund managers to reliably beat the market).

The concept of price efficiency is a useful theory in explaining what markets are trying to achieve, but not so much in what they deliver in practice (although they tend to do a pretty good job most of the time, by hook or by crook, as the article points out).

Along with the cosmos, nature, natural selection, the pace at which rabbits breed and politics, the market is pure chaos. The Golden Mean, or the Fibonacci sequence is the order that automatically derives from chaos. The fact that the market regularly finds support on these Fibonacci retracement levels, proves that the marketplace is an environment of chaos. The results cluster around relatively predictable levels.

When we analyse the price-action, we are actually analysing human behaviour. Human behaviour is fairly predictable when we zoom out. Investors who do not know each, other and whose economic models give a wide range of different answers, agree with each other around these Fibonacci retracement levels. This is the order in chaos.

Well Warren Buffet does not think much of the efficient market hypothesis, in fact heaps scorn on it. There is more to it than just boom and bust. What is a shares value determined by? nothing more than the discounted value of the cash flow (dividends) that it will pay. Even if you sell the share sometime in the future. The cash flow determined by the sale is simply the value of the future dividends.

If you randomly select 20 years and keep them for a year, you will find that some have gone up, some stagnated and others gone down. The question you should be asking is if the information that caused these movements was in the public domain at the start of the period? In most cases the answer would be “yes”. Simply therefore a matter of interpreting it correctly.

If we follow your idea (that hardly any new/price-shifting information ever comes into the market over one year) to its logical conclusion, it means that share prices are discounting what we knew decades ago already, because every day marks the end of a 12m period…

IMO we confuse investment with betting.

A tiny tiny fraction of “investing” is done on public markets. Investing, as into new ventures or expansion of existing capacity. Mostly share issues whether capitalization or IPO.

Virtually all public market turnover of shares is betting. Me as buyer knowing better than X as seller who wants out. That share you bought today at 150 was bought higher or lower by X, but the actual company saw 50 ten years ago when they actually invested that 50 ten years ago.

For every buyer there is a seller – ok there are options that mess with this. You think the price will go up, X disagrees. Time will tell who was correct.

The biggest determinant is the horizon of buyers. I trade very infrequently but substantially when I do. So in past 15y have varied between almost no cash and all equities twice each way and only ever in less than a dozen shares when hold equities.

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