Efficient Market Hypothesis
Part 7 of the the investment sequenceEfficient Market Hypothesis
Wikipedia provides a good introduction to the concepts surrounding the Efficient Market Hypotheesis Efficient-market hypothesis. In Wikipedia:
The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.
Because the EMH is formulated in terms of risk adjustment, it only makes testable predictions when coupled with a particular model of risk.
...
In Fama's influential 1970 review paper, he categorized empirical tests of efficiency into "weak-form", "semi-strong-form", and "strong-form" tests.
These categories of tests refer to the information set used in the statement "prices reflect all available information." Weak-form tests study the information contained in historical prices. Semi-strong form tests study information (beyond historical prices) which is publicly available. Strong-form tests regard private information.
It's important to note two things in a discussion of the EMH:
First, if market A contains market B, then if B is not efficient, A cannot be efficient. In this way, an individual stock is more efficient than the domestic stock market, which is more efficient than the overall global stock market, which is more efficient than the hypothetical market of all assets.
Second, the only way to empirically validate the EMH is to compare historical performance with an asset pricing model (like the liquidity-adjusted CAPM model) and check whether there exists a strategy that beat the market according to this model. If you find one it implies one of a few things:
- The market was inefficient during that time period.
- The pricing model you were using was wrong.
- The strategy succeeded based on luck.
It is, in general, impossible to definitively prove which is the case.
International Financial Markets are Not Efficient
Global financial markets are definitely not efficient:
- Equity home bias puzzle - Most investors hold small amounts of foreign equity despite having a comparative advantage doing so. That being said, this irrational bias has shrunk over time. Equity home bias puzzle
- Feldstein–Horioka puzzle - assuming perfect capital mobility, there should be minimal correlation between the amount of savings by a country and the amount of investment in that country. In reality, however, there is significant correlation Feldstein–Horioka puzzle.
- See also the Backus-Kehoe-Kydland puzzle Backus–Kehoe–Kydland puzzle
- Economists used to believe the expected exchange-rate change must equal the different in interest rates, but abundant historical data has disabused them of this notion Pedersen
Inefficiency Between Asset Classes
Whether the concept of "efficiency" even makes sense between asset classes is debatable given their incredibly heterogenous risks. That being said, there are statistical trends that indicate that it's unlikely any level of efficiency exists here.
First, as I've noted before, no sane person with a realistic risk tolerance should buy bonds, yet people do. Second, based on historical data, the E/P ratio of the previous 5 years correlates with the subsequent 5-year returns for stocks but not housing:
| Asset Class | Slope |
| S&P 500 | +1.35 (CI = +0.18 to +2.52) |
| Housing | +0.18 (CI = -0.22 to +0.58) |
| SP500 - Housing | 1.17 (CI = +0.09 to +2.25) |
The relationship between the PE ratio and stock returns was also also noticed by Shiller Shiller, saying:
Long-term investors would be well advised, individually, to stay mostly out of the market when it is high, as it is today, and get into the market when it is low.
todo Equity premium puzzle and contra
Stocks
Historical Returns
A variety of very simple investment strategies have historically outperformed the market as a whole. I discuss some later. It is, I admit, difficult to definitively that this doesn't reflect (a) random chance, (b) historical factors that no longer apply, or (c) ignores some risk the market participants account for. However, it seem plausible some of these performances represents market inefficiencies.
The more iron-clad proof is that there exist persistent and profitable arbitrage opportunities. For more information see Efficiently-Inefficient.
todo Dividend puzzle
Experts
Warren Buffet arguably stands as a strong counterexample against the EMH. He's argued that some investors predictably beat the market The Superinvestors of Graham-and-Doddsville and has historically done so himself by an average of more than 9% since 1964. However, what is less often touted is that his edge has shrunk dramatically over time and has disappeared since the early 2000s.
Overall Berkshire Hathaway has outperformed the S&P 500 37 of 55 years; the odds of 37+ heads from 55 coin flips is 0.72% - rare, but certainly not implausible in a world of millions of investors. More recently, Buffet himself is skeptical that active management can beat broad based index funds, even making a bet with numerous hedge fund managers that they won't beat thee S&P 500 index - a bet he is currently winning.
Only a minority of actively managed mutual funds beat the S&P 500 index Active management Liu - though critics point out half of invested dollars, by definition, must do worse than the market.
Still, roughly half of "mutual funds" are also actually "closet indexers" - essentially index funds that are technically "actively managed" to justify higher fees Active management - though its unclear if this demonstrates experts think the stock market is efficient or that some mom and pop investors are just rubes.
The general idea that actively managed investments generally performs no better than passively managed ones is widely accepted by economists (absent insider information) Stock Prices.
Tentative Conclusions
Is the stock market efficient? Well, the strong-form of EMH is certainly false: insider trading works. The weaker forms are likely true enough that you shouldn't bother trying to pick individuals stocks (if most mutual funds don't beat the market and Warren Buffet says not to try, you're probably setting yourself up for failure).
I remain uncertain regarding whether certain higher-level strategies can boost your risk-adjusted expected returns, especially given that your risk tolerance probably don't match the market's exactly. We'll come back to that later.
Housing
todo