Efficient Markets Survey

What is your take on market efficiency? Does technical analysis have merit? Does fundamental analysis have merit? Does behavioral finance have merit? Based on what you answered above, how do you make decisions regarding your personal portfolio management?

Is there a particular purpose for this survey? But anyway: 1) Yes (by my definition, at least). Since you need to derive required return from market prices, this reduces “market efficiency” to triviality. 2) Yes, because a significant number of market participants use it. If everyone puts limit orders on Dow 10000, then it will have a market impact. 3) Yes, for the same reasons as 2). 4) Yes, though it is probably more complicated than what we know of. 5) I don’t have the balls to actively trade my personal account. That is what the bank’s/other peoples’ money is for.

No purpose, just curious. The more I learn, the more the facts seem to point at passive buy/hold index investing. Even industry veterans I’ve personally spoke with seem to lean this way. So, if markets are efficient, how do we as financial professionals add value? If academia is incorrect in their assertion, how do you find value with the various avenues of analysis above? (It’s days like today that I really wish JDV was here to offer his insight)

  1. It is mostly efficient, but there is definitely chronic inefficiencies (tech stock bubble, housing etc…). But once you identify an inefficiency it is still extremely difficult to get timing right. 2. No, don’t have any direct experience with it other than always felling people are bullshitting when they start spouting what the chart “says.” 3. Yes, it has to or the market would not be efficient at all 4. Yes!

All those forms of analysis have merit, but they can be applied well or poorly. Work in the markets for one 1 month, watch stocks trade on no news, watch risk re-priced arbitrarily, and I think you have to admit markets cannot be efficient. Saying the market is efficient is effectively lying, in my opinion, although academics would say it making an assumption. Joke: A physicist, a chemist, and an economist are shipwrecked on a desert island. Starving, they find a case of canned pork and beans on the beach, but they have no can opener. So, they hold a symposium on how to open the cans. The physicist goes first: “I’ve devised a physical solution. We find a pointed rock and propel it at the lid of the can at, say, 25 meters per second --” The chemist breaks in: “No, I have a chemical solution: we heat the molecules of the contents to over 100 degrees Centigrade until the pressure builds to --” The economist, condescension dripping from his voice, interrupts: “Gentlemen, gentlemen, I have a much more elegant solution. Assume we have a can opener…”

QuantJock_MBA Wrote: ------------------------------------------------------- > What is your take on market efficiency? > > Does technical analysis have merit? > > Does fundamental analysis have merit? > > Does behavioral finance have merit? > > > Based on what you answered above, how do you make > decisions regarding your personal portfolio > management? 1. You should have learned something in your basic investment class back in college to answer that. You learn that markets are efficient in school, but in reality they never are. 2.,3,4. I believe that firms should use a combination of technical and fundamental analysis as well as looking at behavioral finance so that you can have a 360 viewpoint, and multiple angles to look at things. They all have merit.

Even if you believe markets are completely efficient, financial professionals can add value. Portfolios can be tilted toward various asset classes/styles to gain exposure to certain risk factors - efficiency does not imply that all asset classes or investments offer the same risk/return characteristics. And proper asset allocation for investors’ risk tolerance is still of the utmost importance.

^^^I would take it a step further. Say you believe markets are perfectly efficient: how to you express that view? Many of the tools we have for indexing in fact do a poor job. Read Seth Klarman’s remarks at the CFA annual dinner.

Markets are, for the most part, efficient. Although, the same academics who espouse market effieicney cannot deny that there are definitely “pockets” of inefficiencies: small firms, illiquidity, firms that have no coverage, et al. Technical analysis can be useful insofar as the trading rules become self-fullfilling prophecies as “ohai” suggested.

Markets are not only not efficient, they are downright stupid half of the time.

Bump. Anyone else?

I think behavioral finance will be the next “big thing” as far as trying to predict the markets goes. Maybe we are going to see more PHDs in Psychology going into finance.

QuantJock_MBA Wrote: ------------------------------------------------------- > What is your take on market efficiency? > Markets are generally pretty efficient – straight up arbitrage doesn’t exist for anyone but massively large, computerized trading funds. Chronic inefficiencies exist – ie, Fama/French have shown there is a small cap and value effect, many have done studies on momentum and found it to be persistent in stock returns. I don’t think you can beat the S&P if your world is large cap equities after fees in the long run – but if you’re willing to go into the small cap space, the private world (a la Buffet), special situations, international markets, and other places where there aren’t too many eyes looking to make markets efficient, I think there are plenty of inefficiencies. > Does technical analysis have merit? > Absolutely. > Does fundamental analysis have merit? > Absolutely. > Does behavioral finance have merit? > Sure, but its less obvious how this can be applied – I know some ideas like Thaler’s fund: http://www.fullerthaler.com/strategies/Default.aspx have some really interesting ideas. > > Based on what you answered above, how do you make > decisions regarding your personal portfolio > management? I invest in securities where institutional funds cannot – I look in the microcap space, emerging markets, and other nooks and crannies of the market where the big players, those who keep the markets in check and generally efficient, do not tread. I also buy the Fama/French stuff, and look for value and small cap funds for my 401k, I invest internationally, as you can raise the efficient frontier by investing in int’l funds, and I also try to diversify across asset classes, into real estate, which can also lift the EF. Also, because my 401k is tax advantaged, investing in value and income securities (RE), you get some tax alpha. The combined effects of my retirement passive portfolio and my active personal portfolio creates a 70/30 passive/active split, which is probably ideal for maximizing my IR.

One day Bear Stearns is worth $60, two days later it’s worth $3. The market doesn’t efficiently price securities. I certainly believe that information is rapidly reflected in the market. TA has its merit, only on a short term basis imo for trading. TA is like reading tea leaves. Put a chart in front of 10 people and they will all see something different. Fundamental obviously has merit (It’s why we’re all here).

The markets are inefficient. Why? Because humans are inefficient and humans control the market. Program trading is nothing more than automated human trading, thus it remains inefficient. TA only has merit on a split-second basis, comparing smaller inefficiencies. However, it fails utterly at predicting market movements over anything more than a relatively longer basis, such as 10 minutes. FA has much more merit as does behavioral finance. A combination of the two is very helpful.

  1. not efficient 2*. b/c people use TA in different ways (i.e. use different indicators and different time frames) 3*. and b/c people use FA in different ways (i.e. DCF v. DDM v. EBITDA and multiple v. full model) *without a consensus of all market participants, it is impossible to rely on markets being efficient at any time. both have ‘merit’ but neither is anywhere near perfect, nothing ever will be. 4. yes, but it is qualitative and difficult to measure. watching and attempting to measure risk aversion and expected equity premiums based on behavour could have some merit. 5. i’m young so my portfolio consists of two microcap stocks and i am ready and willing to lose on both, haha.

Markets are nearly efficient. Inefficiencies do exist but persistent inefficiencies are very difficult to find.

  1. inefficient 2. yes, because the use of it has menaingful implications for the market in the short-term 3. yes, because its one of the few time-tested ways that have made money, although that is based on history and could certainly change in a number of ways. 4. absolutely, because it is really one of the few ways to notice and interpret large secular changes. The markets are historically unbelievably awful at pricing these events in. However, using this effectively is a helluva lot more sophisticated and difficult than all the new books/theory makes it seem. 5. i’ve been short for a while and currently get whipsawed on a daily basis. not in the mood to even discuss.

maratikus Wrote: ------------------------------------------------------- > Markets are nearly efficient. Inefficiencies do > exist but persistent inefficiencies are very > difficult to find. If the markets were efficient, or even “nearly” efficient, the tech bubble and mortgage bubble would never have happened. The problems were so endemic and thoroughly distributed that any single firm exceeding risk tolerances of the market would have been punished and nobody else would have endeavored to do the same. This is what the “market” does, punish those who operate outside the bounds of what is expected. Obviously nearly every single financial firm operated well outside of its expected risk metrics. I would actually put forward that the markets are near perfectly inefficient. Humans, as a group (aka “market”), are obviously very bad at realizing the truth. This continues. Look at Greece.

Bob Shiller points out that markets appear to be micro-efficient but not necessarily macro-efficient. In other words, it is quite difficult to outperform the market consistently after transaction costs. It is probably possible to do, but it takes a lot of work, and it is impossible for everyone to do it, so the more people with intelligence and diligence that do it, the harder it is to do. However, markets as a whole can become very overvalued or oversold. This is what he means by markets not necessarily being macro-efficient. Also, different markets are more or less likely to be efficient. Large cap stocks are probably the hardest to outperform, because there is so much information about them that it is hard to come up with legal sources of information that others don’t have. There are some ways to try to beat the S&P500 benchmark that have to do with tilting between the largest components of the index and the smaller components, but that’s about it. Inefficiencies are more likely in the small cap space because there is less coverage and it is more likely that you will come up with information that is not broadly known if you really dig. However, the screening process can be challenging still, and you will almost certainly need to do more than look up values in a database. Currencies are potentially inefficient because there are lots of non-investors active in it - Central Banks, or companies who simply want to hedge out currency risk to increase business predictability, as opposed to maximizing return per unit of risk. In addition, there is no a priori reason that one currency should return more than any other, yet currencies are volatile, so currencies have essentially no risk premium. After all, EUR/USD is just as volatile as USD/EUR, but they can’t BOTH have a positive long-term expected return simultaneously. So technical analysis is most likely to apply when examining systems like currencies, and possibly things like market indices, and also possibly the non-systematic component of individual securities, because there are forces of supply and demand in the short term, and we know that things can get overstretched from any conceivable fair value. We don’t really have any way to figure out how that component of security returns evolves - calling it a random walk doesn’t really help because that would imply that securities can, over time, become infinitely detached from any semblance of fair value and there would be nothing to pressure it back to a more appropriate value range, and that clearly is not the case. We can say that these things are mean reverting to fair value, but they don’t really mean revert in a predictable way, and so technical analysis is a very plausible way to deal with that solution. Remember that good technical analysis is not simply about patterns on charts, but about using these patterns to try to discern what is happening between buyers and sellers. CAPM concludes that markets are efficient because, in effect, everyone has the same time horizon, knows the same information, processes that information the same way, constructs their portfolios with the same procedure, and Lo, guess what, they come up with the same portfolio of risky assets. Big surprise. except that we know that people don’t all construct their portfolios the same way or have access to the same information or have the same time horizons. What’s most interesting about CAPM is not that it doesn’t work, but that it seems to work as well as it does. There is pretty much no other single factor that seems to explain as much about security returns as the average market movement. Even when you add in the Fama-French factors, the contributions of those elements are a tiny fraction of the total R^2 for most securities, compared to the portion of R^2 that can be attributed to the market beta. So you can abandon CAPM and hypothesize efficient markets as a result of no-arbitrage conditions. Markets under this system are supposedly efficient because if they weren’t, an arbitrageur would step in and profit until the inefficiency disappeared. Except that if markets are efficient, arbitrageurs will go out of business, and if arbitrageurs go out of business, then markets have nothing to keep them efficient anymore. So what’s likely to happen is that markets go through phases when they are more efficient and less efficient as arbitrageurs go into and out of business. I like Michael Mauboussin’s approach to markets as complex adaptive systems. He points out that there is this aspect of “the wisdom of crowds,” that means that the average valuation of a large number of observers is probably closer to the true value than the valuation of specific experts. However, there are three conditions that are required: information needs to be reasonably well disseminated (not necessarily perfectly, but just reasonably well), there needs to be some kind of aggregation system (like the market price mechanism), and there needs to be a diversity of perspectives and valuation techniques. When these conditions hold, markets are often pretty efficient. The big problem, according to Mauboussin, is when there is a breakdown in one of the facilitating conditions, and the most common breakdown is the “diversity” condition. So when everyone is in the same trade: Mortgages, or Bearish Dollar, or Bearish Euro, or Tech Stocks, or whatnot, then you tend to have a diversity breakdown and prices can way way overshoot. OK, enough on efficient markets. Markets are clearly not completely efficient, and often grossly inefficient, but don’t let that make you think that it’s therefore easy to outperform a passive index on a consistent basis, particularly if you are managing other peoples’ money.