ASX Education: The inefficient market hypothesis
INEFFICIENT MARKET HYPOTHESIS
You may have heard of ‘EMH’, the ‘efficient market hypothesis’. Anyone who’s read the introduction to any text book on financial theory can tell you all about it.
EMH basically says that you can’t beat average returns because the markets are at all times “informationally efficient”, that is to say all prices reflect all available information at all times. One form of EMH, the “strong EMH” suggests that this efficiency of information extends beyond publicly known information to all information including insider information, which it has to be said, in Australia, in some of those small stocks, is probably not far off the mark.
The theory has been rubbished as theory, and there are many very plausible reasons why it should be, but none as obvious as the fact that if were it true, the whole financial advisory industry would be out of a job because no-one would be able to add value.
If all known information was instantly reflected in all share prices the only way brokers, fund managers, analysts and taxi drivers could possibly add value would be in knowing the unknown, which is impossible, so the only way we could add value would be to guess and it follows that if all anyone could ever do is guess then all investment outcomes and fund performances would simply reflect the normal distribution curve of a random outcome and brokers, fund managers, research analysts would hold no advantage over Joe Bloggs in front of his CommSec screen.
Normal distribution of random returns:
So if the efficient market hypothesis were really in effect all fund amangers and investors were guessing the future instead of knowing the future, then all fund amangers would be part of the bell curve of random returns and the successful ones, whilst they would market themselves, their investment philosophy and their brilliance would simply be marketing their luck, because there would be no good or bad fund managers, just some lucky ones.
The industry would also die, because luck is not something anyone would pay for.
Of course we don’t want to get too carried away with theory, after all, you can pretty much guarantee that anyone who took the time to write an academic paper about the stock market being guesswork wasn’t a fund manager, didn't know for sure and was more interested in academia than real life.
But the theory does raise the interesting question whether there isn’t some significant truth in here somewhere.
Thankfully I have another theory, one that goes to the core of making money in the stock market but is rarely voiced, until now. It is this. The “Inefficient Market Hypothesis”.
The Inefficient Market Hypothesis is based on one indisputable fact:
“The most money will be made in the stocks that the analysts get the most wrong.’
Think about it. Every year the top and bottom performing stocks are not the stocks the market predicts most accurately; those stocks will hardly move, the big money is always in the stocks that the market got most wrong.
In other words, you will not make money knowing what everyone knows. You will not make money listening to an adviser telling you about consensus forecasts, PEs and yields, or calculating valuations based on accurate forecasts. All that is valueless, because it is in the price.
The only thing that will make you money is knowing what is not in the price, and that means working out what assumptions the market has got wrong, not right.
In my inefficient market hypothesis there is more money in analytical failure that victory and the most fertile ground for failure is in the big assumptions, in the big drivers. In the correction in October last year for instance the market was wrong to assume: there would be a trade war, interest rates would rise, recession was coming, US technology stocks were overpriced. Thinking the opposite, having an open mind, being objective about the stampeding herd, is where the money is, it is also when prices are at their 'best', at the top and at the bottom.
And what of today’s assumptions?
- Interest rates are going to fall.
- The US and China will muddle through to some trade compromise.
- Global growth will slow down.
- The Chinese economy is well managed.
- Inflation is going to remain benign for years.
- The banks are ex-growth.
- The iron ore price will stay up for years because of Vale.
- The Aussie dollar is down and will stay down.
- Afterpay will grow its business unchecked in the US and Europe.
- The housing market will bottom.
- Trump is a genius.
- Trump is an idiot.
Ask yourself – what is everyone assuming in current share prices. then question it. Its a much more useful employment of your precious investment attention than simply agreeing.
We are making some mistakes somewhere. You just need to know where because there is a fortune in knowing what we are getting wrong.