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 Harry Potter film “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. However, towards the end, he turned out to be a fluke.
The reason to mention this here is to throw some light on the term “Efficiency”. Even Nicolas Léonard Sadi Carnot, the inventor of the infamous Carnot Engine, claimed that nothing can ever achieve 100% efficiency.
What does it mean to be ‘efficient’? Efficiency is the ability to achieve maximum productivity with minimum wasted effort or expense. Sounds cliché, doesn’t it? In the case of markets, this term evolves from an uncanny origin. It refers to the coverage of all the relevant information available to the speaker by the prices of stocks and securities.
So, is the stock market efficiency, and if it is, 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!
Traders, in our long history of war in the battle field of the markets, have been continuously bombarded with sales pitch from experts, claiming to have discovered the holy grail model that guarantees investment success. You can even formulate a low-risk high return portfolio using the secret strategies 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 rather diversify across a broad band of stocks than trade often. They wouldn’t pick undervalued or overvalued shares and try to time the market.
On the flip side, if you are incredulous 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 with a far lower return than your uncle who invested in an index fund, which is a loss-loss situation.
As prevalent, it cannot be deduced with utmost certainty 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, analysing 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 always be equal to the true value of the stock. 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. It follows the idea 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) make it impossible for investors to either purchase undervalued stocks or sell overvalued stocks. 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 would have 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.
Nothing Changes, if Nothing Changes
Market Efficiency turns out to be a hypothetical concept. It might hold true in the same world where evolution never happened and humans don’t even exist, or rather a world still inhabited by apes! But contrarily, it is not completely useless. It can provide a financial description of the markets. Unfortunately, it is not evident enough because it doesn’t provide any testable condition of the financial market. So traders, gear up and do your research well! Remember, the power is in you. All you have to do is invoke it at the right time. Cheers!