3 Misconceptions about Market Efficiency
Market efficiency is one of the core components of many people’s approach to investing. Although it is often misunderstood and this can lead to some dismissing it entirely.
The concept of market efficiency is mainly cited from Eugene Fama’s seminal paper in 1970, “Efficient Capital Markets: a Review of Theory and Empirical Work,” Fama defined the market to be “informationally efficient.” What that means is, in essence, prices in each moment incorporate all available information about future values.
How this occurs is a natural byproduct of a competitive market. As traders can enter a market relatively easily and at a low cost with institutional investors having access to leverage easily. Mispricings could be extremely beneficial to traders to exploit as they simply could arbitrage them.
An arbitrage simply is a description of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit in a risk-free manner.
Due to this, the extremely high degree of competition in financial markets from traders and algorithms means these mispricings are typically traded out of existence. If all pricing comes back to supply and demand. Then the price would be expected to correct if it was sufficiently out of kilter with the consensus, bringing it back into equilibrium or an ‘efficient’ price based on knowable information.
Whether you believe the market is efficient or not. It is irrefutable that developed markets certainly behave as if they are efficient. In an efficient market, prices would be extremely difficult to predict and as a consequence, most active managers would underperform after costs. This is exactly what occurs. The evidence is overwhelming that active managers, although incredibly well funded, in the majority struggle to beat their respective benchmarks.
Despite this, it remains one of the most contentious areas in finance. Whether this is human pushback to a concept that feels ‘unnatural.’ Or, the various anecdotes which appear to dismiss market efficiency. Such as Robert Shiller’s ‘Irrational Exuberance’ of the 2000’s tech bubble and the existence of the ‘Santa rally’ (the fact that markets tend to perform well before the end of the year). It seems illogical that both a market can be efficient and seemingly irrational.
There are however some key misconceptions about market efficiency which can help enhance our understanding of this.
MISCONCEPTION 1 — An efficient market is one of ‘perfect pricing’
There is no such thing as a ‘perfect price’ of security. An efficient market is subject to corrections as new information becomes available. An example of this would be the COVID crash of March 2020. It is not that the market was ‘wrong’ prior to the extent of the COVID crisis. It is that as new information became available to market participants in a way which was significant enough that the market began to price this effectively.
A security’s pricing is one of consensus and this does not have a direct relationship to ‘perfect hindsight-driven pricing.’ It is absolutely possible for prices to change as new information and a new consensus develops. The question is more for the investor — are we certain enough of our position to go against the consensus of the market in a way which we can exploit? This is best summed up by a response from Richard Roll, an academic financial economist to Robert Shiller in response to market inefficiencies:
”I have personally tried to invest money, my client’s money and my own, in every single anomaly and predictive device that academics have dreamed up. … I have attempted to exploit the so-called year-end anomalies and a whole variety of strategies supposedly documented by 23 years of academic research. And I have yet to make a nickel on any of these supposed market inefficiencies … a true market inefficiency ought to be an exploitable opportunity. If there’s nothing investors can exploit in a systematic way, time in and time out, then it’s very hard to say that information is not being properly incorporated into stock prices.”
While the spoils are most certainly there for the contrarians, when right. The vast majority of market participants find themselves ‘bleeding at the side of the road’ while trying to outguess the market. Market pricing is based on one of the most complex and adaptive systems we know. Those who go against that on the basis of single narratives, often embroiled in various biases, can find themselves in deep trouble. Even if you are right, you also have to be right for sufficiently long enough for the collective consensus to come into line:
“The market can remain irrational for longer than you can remain solvent.”
MISCONCEPTION 2 — Human biases cannot exist in an efficient market
An efficient market is just one which reflects available information. It is just that, information. An interpretation of the information being ‘right’ is a human and subjective view. Therefore it is fully within the concept of market efficiency for Gamestop pricing to exist. As far as, investors exhibit a preference for a certain security separated from its fundamentals.
MISCONCEPTION 3 — A market is ‘fully efficient’ or ‘not at all’
Andrew Lo cited the concept of ‘Adaptive Markets.’ These are ones where efficiency develops as the maturity of markets does. In effect, how efficient a market becomes is a dimmer switch, not an ‘on’ or ‘off.’ Lo cites similarities to Darwin’s theory on evolution stating that markets themselves go through phases of development where they become more efficient the more mature the market is.
The academics are still debating this, but this framework could provide a guide to understanding how liquidity can impact the development of markets. It could provide a bridge between the very data-driven elements of asset pricing and the stages less developed markets progress through to arrive at efficiency.
What can investors take from this?
This comes down to what I believe is my conclusion on the views toward market efficiency. Much of the confusion about “efficiency” is down to ignorance of this definition. Market efficiency does not claim that pricing is perfect. It is just an explanation that pricing reflects available information and available information can be deeply flawed and inaccurate in hindsight.
What should be considered a more relevant question for the investor is if investors can perform better than the consensus? Are our individual biases and blindspots less risky than the consensus?
Whether like in physics we are yet to find a truly unifying theory of general relativity and quantum mechanics. In finance, we are yet to find a theory which spans the mathematical pricing of market efficiency and behavioural economics. If you would like to learn more about this then there is no better place to start than the debate between the 2 biggest names in Academic and Behaviouralist Finance, Eugene Fama and Richard Thaler which you can watch below:
The behaviourists may be entirely right that market efficiency is, in many ways, a flawed model but they themselves fail to provide any other legitimate alternative. It is after all, far easier to be reductive than conclusive.
I would argue that like in physics, without a robust unifying theory, it does not matter how devout a follower you are of quantum mechanics. If you decide to walk off the top of a 100 ft high building, you will still feel the full weight of gravity as you fall. To the same extent, it does not matter how much you believe in market inefficiencies if this belief will likely lead to sub-optimal investor behaviour.
Until we can find a better theory which creates a better framework for pricing than the 5-factor model and until there are more conclusive alternatives which can describe our reality. For now, investors would be better served keeping both feet placed firmly on the ground.
