This post was originally made on July 18, 2006 on a former blog of mine.
Every trader has his reason why markets are not efficient. Of course, he believes so because he has to believe that he can make a profit from market inefficiencies lest he be wasting his time trying. The efficient market hypothesis states that all publicly available information is factored into the stock price (the “strong” form of the EMH even suggest that inside information is factored in as well) and, therefore, on average you should not be able to make abnormal returns based on publicly available information.
What we mean by “abnormal” returns are returns that do not reflect the expected return generated by an asset pricing model like the capital asset pricing model (CAPM). Abnormal returns are also referred to as “alpha”.
The faulty assumption by many traders is that one can make abnormal returns in an inefficient market. Let’s just say that markets are inefficient and all that that implies. The next question we have to ask ourselves is, “how are we going to profit from those inefficiencies?” If efficient markets suggest an inability to make abnormal returns then do inefficient markets suggest one can? The answer is not entirely clear. Just because the market is inefficient does not mean one can expect to make abnormal returns.
Let’s do a little thought experiment. Suppose you believe the market to be inefficient and you have determined that the “real” value of Stock A is $50 when in fact it is trading for $40. Your idea then is to buy Stock A at $40 and hope to sell it at a profit at or near $50. The question you then have to ask yourself is, “in an inefficient market how can I expect the price to eventually rise to $50?”
In efficient markets it is presumed that all people act in a rational manner with all the information they have access to. Therefore, the price should reflect the rational expectations of the investing population as a whole at any given point in time. If you presume that markets are inefficient then you are in essence saying that people do not act rationally given all the information they have. If that is the case then how can one predict where the stock price will be or could be in the future? Irrationality breeds uncertainty. That is to say, if you believe the true price is $50 you are expecting the market to act rationally and move it there when in fact you have to presume irrationality in order to believe you are presently getting the stock at a discount. Is this a logical thought progression? Does the market swing from rationality to irrationality? If so, how do you know when one state is dominant over the other? What you are basically saying is that you have found a model (based on publicly available information) that tells you that this stock is undervalued. Since no one else presently has this information you are presuming they will eventually “get it”. So, either your private analysis of the information must become the public opinion or some other non-related catalyst must spur the stock upwards. Is either of those things a plausible long term bet? I don’t have the answer but the inclination is to believe that even if markets are not efficient, it would be extremely difficult to profit from them.
Perhaps markets do swing from rationality to irrationality and the reason could be behavioral and not necessarily fundamental. If that is the case then your ability to profit lies in your ability to predict human behavior and emotion. This is perhaps why we get speculative excesses that seem to go on forever. If you are adept at reading the pulse of man then more power to you. Man’s behavior is a fickle thing and I cannot presume to predict his (aka Mr. Market’s) mood on a daily basis.
My conclusion from this thinking is relatively simple. Even if I could prove today that markets are inefficient, I am not so sure I could then prove that there would be a way to consistently profit from that. Sure, there would be things to exploit that come and go but those opportunities would not last long (minutes or hours maybe?) Abnormal returns are hard to come by whether the market is efficient or inefficient. Good luck finding them.
“The essence of the efficient market thing is, after all, as we in economics have always held: There’s no free lunch.” -Merton H. Miller
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