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Firstly we must accept that the market is ‘wrong’ about every share every day in the sense that it does not perfectly predict the future. So, in this area of thought and evidence we are not looking for the market to have a flawless crystal ball.
A more reasonable question, if long one, is: does the market in a systematic way (a biased way) mis-price certain categories of shares, those with common features, such as low cyclically adjusted price earnings ratios, to such a degree that, over time, you could purchase a portfolio of such shares and thereby gain a long-term return that out-performs the market (without taking on addition risk)?
The most productive area of enquiry into mis-pricing is under the domain name of semi-strong form efficiency. Under this paradigm, share prices fully reflect all the relevant publicly available information.
This includes not only past price movements but also earnings and dividend announcements, rights issues, technological breakthroughs, resignations of directors, and so on.
The semi-strong form of pricing efficiency implies that there is no advantage in analysing publicly available information after it has been released, because the market has already absorbed it into the price. Expect to earn thereafter merely the going rate for the level of risk you are prepared to accept.
(But there is a randomness element, a possibility that you can out-perform, but this is due to random chance rather than anything systematic – you could just as easily be hit by bad luck. Many investors confuse their good luck with their genius, of course. When it goes wrong they attribute that to bad luck (Behaviouralists call this asymmetry of the treatment of the randomness of life”self-attribution bias”))
(The three levels of efficiency testing, weak-form, semi-strong form and strong form, were defined in the Newsletter posted2oth September 2017)
Today I want to give an overview of where we are in the academic literature on pricing efficiency. Tomorrow I’ll start presenting the thought of some great investors on the subject, with Peter Lynch’s view. The postings in the following few days will give the views of John Neff, Benjamin Graham, Warren Buffett and Charles Munger.
Sorry to disappoint you, but…….the market is mostly efficient
I’ve already shown some of the evidence on departures from semi-string efficiency in many Newsletters over the past year. Despite this evidence, I conclude that for most investors most of the time the market may be regarded as efficient.
This does not mean the search for anomalies should cease. The evidence for semi-strong efficiency is significant but not so overwhelming that there is no hope of out-performance for the able and dedicated.
While the volume of evidence of pockets of market inefficiencies is impressive, we need to be wary when placing weight on these results.
Given the fact that there have been thousands of researchers examining the data it is not a surprise that some of them find plausible looking statistical relationships indicating excess return opportunities.
The research that actually gets published tends to be that which has ‘found’ an inefficiency. The research that does not show inefficiency receives much less publicity.
Furthermore, the excess return strategies may be time specific and may not continue into the future.
Incentive not to publish the best results?
On the other hand consider this: suppose that you discover a trading strategy that produces abnormal returns. You could publish it in a respected journal or you could keep it to yourself.
Many would select the latter option because publishing may result in the elimination of the inefficiency and with it the chance of high investment returns.
So there may be a lot of evidence of inefficiency that remains hidden and is being quietly exploited.
The great paradox
There is a strange paradox in this area of finance: in order for the market to remain efficient there has to be a large body of investors who believe it to be inefficient.
If all investors suddenly believed that………………..
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