Inefficient Markets

Been reading on the topic of behavioral finance, which is based off the foundation that markets are highly inefficient.

Interesting how everything in modern finance (including like 90% of what I study) is based off the usual no-arbitrage-markets-are-perfectly-efficient-prices-convey-all-information assumptions. Which, as increasingly shown in theory and in empirical evidence, is completely untrue. Kinda makes you wonder about why you’re doing a Masters in Finance and Economics. (Well, I guess if I didn’t do my Masters I wouldn’t have known that whatever I’m studying is completely untrue in the first place)

So what’s the Efficient Markets Hypothesis (EMH)? It assumes that:
1. Investors are rational and value securities for their fundamental values. Hence, security prices incorporate all available information immediately and prices adjust to new levels according to net present values.

2. Even if some investors are not rational, their trades are random and therefore cancel each other out without affecting prices.

3. Even if investors were irrational and that their trades do not cancel out, arbitrageurs will eliminate their influence on market prices, bringing prices to their “true” levels.

Why the EMH would be untrue even in theory
1. Investors aren’t rational, and they don’t follow the usual von Neumann-Mogenstern rationality functions. For example, investors are notoriously loss averse, usually reluctant to sell a losing stock.

2. Individuals systematically violate maxims of probability theory in their predictions of uncertain outcomes. In other words, investors have completely wrong ideas about the states of the world and their true risk. For example, they may extrapolate short past histories of rapid earnings growth of some companies too far into the future and therefore overprice these companies.

3. Investors do not deviate from rationality randomly – they do so in the same way. As a result, buying and selling are highly correlated across investors.

4. Real-world arbitrage is risky – so arbitrageurs would not be as effective as postulated by the EMH. Arbitrageurs face unpredictability in future resale prices, liquidity, and further drawdowns in their marked-to-market portfolios.

Still not convinced? Here are some real world examples of why EMH doesn’t work:

1. Research has shown that stock prices tend to “trend” in the short term (6 – 12 months), hardly in line with the mean-reverting behavior as predicted by EMH. (any surprise why I’d a firm proponent of trend-following?)

2. EMH postulates that stock prices will only react to changes in fundamental values, ie they should move in response to new information. However, many of the 50 largest one day stock price movements in the US since WWII came on days of no major economic news – including Black Monday (19 October 1987) when the Dow Jones Industrial Average fell by 22.6 percent – without any apparent news.

3. Orange juice is produced in a concentrated region, so the price of OJ futures should be largely affected by supply-side factors like weather. However, the evidence shows that weather only accounts for a small portion of OJ prices.

4. The stock price of a company usually rises once it is included in the S&P 500 index. This inclusion is a purely mechanical process, and does not affect the fundamental earnings of the underlying company. Yet, mere inclusion into the index seems to boost the stock price, contrary to EMH which states that the price should only be affected by the NPV of its future earnings.

Markets aren’t efficient. And people who invest based on this belief are fooling themselves.

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One response to “Inefficient Markets

  1. Pingback: Carrying the Dollar « The Eggonomist

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