There are underlying laws and theories that rule the market. Investors may not be aware of this and many deliberately don’t pay attention. However, it is still important to know such theories to understand the market better. One such theory is the Efficient Market Hypothesis (EMH). Have you heard of this before?
What is the Efficient Market Hypothesis (EMH)?
Basically, the efficient market hypothesis (EMH) is an investment theory that says you can’t “beat the market.” This is because stock market efficiency causes share prices to price in all relevant information.
The EMH tells us that stocks always trade at fair values on exchanges. What is fair value, by the way? The fair value is the sale price that the buyer and seller agreed to. The market where the security is traded determines the fair value of that security.
What about EMH? In effect, investors cannot buy undervalued stocks or sell them for inflated prices. Further, this implies that it’s impossible for you to outperform the overall market. Even if you use expert stock selection or market timing, it’s just impossible to beat it. The efficient market hypothesis (EMH) posits that you can only have higher returns if you buy riskier investments.
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Breaking It Down Further
Although the efficient market hypothesis suffered intense debate, it has been used in finance and economics as the fundamental theory that explains asset price movements.
As mentioned, the accepted view is that markets operate efficiently. All stock prices reflect all information accurately. All participants know the same information so price fluctuations are unpredictable. Plus, they respond to right away to new market details.
Therefore, the efficient markets don’t let investors earn higher than average returns without extra risks.
However, as history proves, markets do not always behave rationally. To make this opposition stronger, the EMH cannot explain excess volatility. Even if this theory is the prominent finance theory, proponents of behavioral finance believe in biases that drive investors’ decisions.
The Efficient Markets
Efficient markets are the basis underpinning financial decision making. During the early 1960s, Nobel Prize winning economist Eugene Fama came up with the efficient market theory. Up until now, the theory obtains acceptance across the financial field.
The logic goes like this: all subsequent price changes reflect a random departure from previous prices. Share prices reflect all available information, so tomorrow’s prices are independent of today’s prices. They will only reflect tomorrow’s news. News and price changes are unpredictable. Therefore, both a novice and expert investor will get comparable returns.
What It Means for Investors
Proponents of the EMH say that you could do better by investing in a low-cost, passive portfolio. Through its June 2015 Active/Passive Barometer study, Morningstar Inc supported that conclusion with the data it gathered.
Morningstar compared active managers’ returns in all categories with a composite made of related index funds and Exchange Traded Funds. The study found that only two groups of active managers outperformed passive funds more than half the time year-over-year. What were these two groups? US small growth funds and diversified emerging markets funds.
Other categories included US large blend, US large value, and US large growth. In all of these categories, investors would have achieved better results if they invested in low-cost index funds or ETFs.
Even if a percentage of active managers outperformed passive funds at some point, what were the odds? The challenge for the investor was to identify which ones would actually perform that well. Less than a quarter of the top-performing active managers managed to consistently outperform passive ones.
3 Different Forms of Market Efficiency
We all know that news travel via different media from different sources. According to Fama, this represents 3 different forms of market efficiency: the strong, semi-strong, and weak form.
The Strong Form
This is market efficiency where all info (public, personal, and confidential) manifests in share prices.
This means that investors cannot get an edge over others. This also minimizes insider trading. Ultimately, the strong form suggests that you cannot achieve above average returns no matter what kind of info you hold.
The Semi-Strong Form
This one proposes that share prices are a reflection of information available to the public. Because market prices already reflect market info, you cannot gain abnormal results even if you use fundamental analysis.
The Weak Form
This is, as the name suggests, the weakest of the three forms. It claims that stock prices are a reflection of today’s price. Therefore, technical analysis is not a useful tool if you want to predict future price movements.
The Efficient Market’s Failures
Despite the accuracy of the efficient market hypothesis (EMH) throughout financial research, it has fallen short throughout history.
Even though a huge number of academics support the efficient market hypothesis (EMH), detractors also exist in equal number. For instance, Warren Buffett, an investing legend, has consistently beaten the market over long periods. If the EMH really works, Buffett could not have done that.
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During the 2008 Financial Crisis, most financial theories trembled for their lack of market-practical perspective. In other words, if the EMH had stood its ground, the housing bubble and crash wouldn’t have taken place.
Efficiency also didn’t explain market anomalies. These anomalies include speculative bubbles and excess volatility. When the housing bubble peaked, and investors poured funds into subprime mortgages, irrational behavior preceded the markets.
Investors totally failed to meet rational expectations. They acted seemingly irrationally viewing potential arbitrage opportunities as their saviors. If the EMH really worked, the efficient market would have adjusted prices to rational levels.
Critics also point to the 1987 stock market crash. During that time, the Dow Jones Industrial Average declined by over 20 percent in one day. This was taken as an evidence that stock prices can significantly deviate from fair values.
Aside from its failure to explain financial downturns, the theory has been scrutinized and criticized. For one, theoretically, every person can access and rip apart info at the same pace. However, information channels have been growing in number, with the social media and internet at the forefront. This makes even the most updated investors fail to monitor every piece of information.
Therefore, emotions, rather than rationality, seem to influence investment decisions more.
Similar to any new research, the behavioral finance started with the anomalies that the current wisdom (the EMH) couldn’t address.
As a new field of study, behavioral finance aims to connect cognitive psychology with traditional finance. Its ultimate goal is to explain irrational investment decisions.
The main argument of this study is based on the idea that investors have behavioral biases. Frequently, behavioral biases come from cognitive psychology applied to financial markets. The following are some of the most common biases.
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This trait is commonly used outside finance. However, when it comes to investing, overconfidence refers to an investor’s intuition to overestimate his or her ability to process information. Thus, he overestimates his or her ability to pick winning stocks.
This one refers to an investor’s tendency to anchor his or her thoughts to a reference point. And this reference point is often his or her initial decision. Then, he or she refuses to drop it even in the face of new information.
Hindsight bias is the belief that past events were predictable. Therefore, they should be acted upon at that time. Oftentimes, the hindsight bias can make an investor rationalize previous errors. Eventually, it may lead to overconfidence.
This bias is associated with flipping a coin. When you flip a coin, you always have a 50-50 chance of getting heads or tails. That’s true even without considering the previous flips. In investing, many investors do not realize that past events are independent of future ones.
Those are just the most common biases that investors exhibit. There are still many other biases in decision making. Considering investor bias, stock mispricing can happen in predictable ways.
In other words, markets do not really price assets as rationally as the EMH claims. What you have to do is to identify your biases, recognize mistakes, understand other people’s decisions, evaluate market trends, and plan for the future.
If you plan to construct a portfolio using the behavioral approach, you should incorporate multiple layers that have distinct goals. For instance, the lower layer should hold low risk assets to minimize potential losses. A higher level is for attempting to maximize returns.
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Many concepts of behavioral finance tend to contradict those of the efficient market hypothesis. It will not be wise to discount one of them or the other. Here’s what you should do: do your research and make decisions with an eclectic standpoint.