When we talk about efficiency in markets, we are referring to the speed with which new information is accurately priced into securities. In a very efficient market, any new information which has a material effect on asset value will be factored into the price of the asset very quickly. In fact, the revaluation will occur so fast so as to make it almost impossible to benefit from first mover advantage.
Inefficient markets on the other hand take time for new information to be accurately distilled into asset value. Even if the information has an immediate effect on price, it will take some time for the price to accurately account for the new information.
Take for example a stock that is trading at $100. Let’s say that the company reveals that its earnings will be 10% lower than what was previously forecast. If the market quickly adjusts to the new news, we can say that the market is efficient. If the market fails to act on the news immediately, or takes some time to accurately reflect the new information in the price, then the market could be said to be inefficient.
The Efficient Market Hypothesis (EMH) was first proposed by the French mathematician Louis Bachelier at the turn of the last century, and was further developed by Professor Eugene Fama in the 1960’s. In essence, the theory says that it is impossible to consistently outperform the market using information that is already known by the majority of investors. They argued that the major stock markets were so efficient that only luck could lead to an investor beating the market in the short term.
This proposal has serious implications for technical analysts. All the information used by chartists is based on historical share price and volume, and as this information is widely known by the market, no amount of analysis could lead to an outperformance.
The EMH has led to the development of Random Walk theory. The theory argues that because modern stock markets are so efficient, and because the timing and nature of new information is a random process, share price direction is also an entirely random phenomenon.
This idea was tested by an ingenious experiment devised by Burton G. Malkiel, an economics professor at Princeton University and writer of A Random Walk Down Wall Street. He started with a hypothetical stock valued at $50. He would then generate a share price chart by flipping a coin each day. If he got heads, the stock would rise by 50c; if he flipped tails the stock would lose 50c. The charts were then presented to a group of chartist who were asked to forecast the direction of the stock. The chartists were able to argue with conviction what direction the share price would take based on the chart patterns and the various indicators they employed. But the method for generating the charts was completely random, and hence it was impossible to predict future movement!
So does that mean that the very idea of trading is defunct? Are we all wasting our time? I would argue that while there are valuable lessons to be learned from these ideas, a trader still has the potential to beat the market.
The most important thing to stress is that while EMH and random walk are unassailable from a theoretical standpoint, they are based on a concept which is far from proven. That is, the degree of efficiency in the market. There is no question that the major stock markets are certainly quite efficient, but not perfectly so. It is very common to see a share price over or under react to a given piece of news, and this creates opportunities for the objective trader.
Also, a stock’s price is subject to a large number of variables. We all know too well that the market can be influenced by anything from macro economic factors, the market’s perception of management quality and even geopolitical stability! On any given day there could be a wide range of factors at play, and the market will often take time to accurately digest and factor all the information into share prices, and again this gives the smart trader an opportunity.
Another factor to consider is that because technical analysis is so widely practiced, there is a degree of a “self fulfilling prophecy” about it. If a significant proportion of the market is expecting the market to turn down due to the technicals, and they all then act on the expectation by selling, then the market will in fact go down. Now did that happen because of all the technical based selling, or would it have happened anyway? The trader would say – “who cares, the fact is it works”!
Finally, these theories reinforce to us the importance of money management strategies. To a large extent, whether we are right or wrong in our predictions is less important than how we deal with our gains and losses. Seasoned traders are successful primarily because they know to cut their losses quickly and allow their winning trades to run. They expect to take bad trades regularly, and simply factor this into their overall plan. As long as they win more often than they lose (even if they only get it right 51% of the time), and as long as they exit losing trades quickly, they know that their net position will continue to grow.
A fairly recent and exciting area of research is Behavioral Finance (sometimes called behavioral economics). This posits that an understanding of psychology and human emotions (such as greed and fear) can be used to explain, and in some cases predict, the reaction of market participants to certain types of information. The main thrust of this school of thought really reinforces what traders have long known – that is, that market participants are irrational and emotional beings. As such, it’s not reasonable to expect that markets can ever be entirely efficient, and from a traders perspective, that is very good news indeed.
Until then, happy investing.