Efficient market theory (notes of math 210H)

There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. h eir analytical models are widely known and employed.


Because of the collective ef orts of these participants, information is rel ected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.


Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.


Assets therefore sell at prices from which they can be expected to deliver risk- adjusted returns that are “fair” relative to other assets. Riskier assets must of er higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no
incremental return that is not related to (and compensatory for) incremental risk.


I agree that because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information’s significance. I do not, however,believe the consensus view is necessarily correct.

To beat the market you must hold an idiosyncratic, or nonconsensus, view.


Although the more efficient markets often misvalue assets, it’s not easy for any one person—working with the same information as everyone else and subject to the same psychological influences— to consistently hold views that are different from the consensus and closer to being correct.


Mutual funds are rated relative to each other. The ratings don’t say anything about their having beaten an objective standard such as a market index.


The fact that the Warren Bufetts of this world attract as much attention as they do is an indication that consistent outperformers are exceptional.


Every once in a while, then, people learn an essential lesson. They realize that nothing— and certainly not the indiscriminate acceptance of risk— carries the promise of a free lunch, and they’re reminded of the limitations of investment theory.


• the asset class is widely known and has a broad following;
• the class is socially acceptable, not controversial or taboo;
• the merits of the class are clear and comprehensible, at least on the surface; and
• information about the class and its components is distributed widely 
and evenly.
If these conditions are met, there’s no reason why the asset class should systematically be overlooked, misunderstood or underrated.


Where might errors come from? Let’s consider the assumptions that
underlie the theory of efficient markets:
• There are many investors hard at work.
• They are intelligent, diligent, objective, motivated and well equipped.
• They all have access to the available information, and their access is
roughly equal.
• They’re all open to buying, selling or shorting (i.e., betting against) every
asset.


But it’s impossible to argue that market prices are always right. In fact, if you look at the four assumptions just listed, one stands out as particularly tenuous: objectivity. Human beings are not clinical computing
machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.


Whereas investors are supposed to be open to any asset— and to both owning it and being short—
the truth is very different.


A market characterized by mistakes and mispricings can be beaten by people with rare insight. h us, the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It
does not, however, guarantee it.


Respect for ei  ciency says that before we embark on a course of action, we should ask some questions: have mistakes and mispricings been driven out through investors’ concerted efforts, or do they still exist, and why?


All that means is that prices aren’t always fair and mistakes are occurring: some assets are priced too low and some too high. You still have to be more insightful than others in order to regularly buy more of the former than the latter.


Swallowing theory  whole can make us give up on finding bargains, turn the process over to a computer and miss out on the contribution skillful individuals can make. The image here is of the efficient-market-believing instance professor who takes a walk with a student.
“Isn’t that a $10 bill lying on the ground?” asks the student.
“No, it can’t be a $10 bill,” answers the professor. “If it were,someone would have picked it up by now.”
The professor walks away, and the student picks it up and has a beer.