Sapienter Wealth Management

Efficient Markets: the evidence

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The article published in The Financial Times by John Authers of 28 Sept 2009 entitled Wanted: new model for markets, contained a series of inaccuracies and non-sequiturs in relation to efficient markets. Efficient Markets borrowed from mathematics but that is widely regarded as an oversimplified and often downright misleading theory that fostered the cavalier confidence leading to the crash. The branch of mathematics at stake (statistics) has been used legitimately. Since the start of the 20th Century when Bachelier first applied statistics to the stock market, studies up to the 1950s by various academics and businessmen into asset prices have equally observed their random character. From the introduction of computers in 1950s, empirical studies began to be undertaken. These also showed that stock market prices (equities, bonds, commodities) did not run in patterns which were predictable. Such observations tended to rule out any value in technical analysis (past performance is no guide to the future). Furthermore, the variables seemed to be wholly independent or unrelated, meaning fundamental analysis (stockbrokers tips) were equally useless to investors. No wonder then that this area of research has been and remains highly controversial. Eugene Fama produced in 1965 an hypothesis on the Behaviour of Stock Market Prices. Building on the work of others, he showed how the Random Walk Hypothesis adequately described the movement of asset prices. The work included the weak points of the hypothesis, which have been known and accepted since the start. To begin with, the Random Walk Hypothesis is only a model and as such not fully representative of the reality it portrays. The emphasis from Fama has been to explain what the shortcomings in the hypothesis mean to investors. These include where the prices do not fit the model perfectly (Fat Tails or Leptokurtosis); and where the average price and volatility of an asset alters in different time periods (non stationary variables or Heteroscedasticity). To get around these shortcomings, the taking of a great number of observations over long time periods is considered adequate to allow for a certain approximation in the model (Central Limit Theorem) making it acceptable mathematically. Talk of oversimplification, however, is illegitimate. Having laid the theoretical foundations, Mr Fama and others then proceeded between 1965 and 1970 with larger computer power and newly acquired data (Centre for Research in Security Prices CSRP) to produce numerous studies which amply showed how the Random Walk Hypothesis was borne out empirically. Statistical tests (where correlations approach 0) were used to demonstrate that price data was unrelated (meaning no predictable patters), whilst mechanical trading rules were built which showed their inability to provide greater profits than a buy and hold strategy. Analysts or Stockbrokers tips (fundamental analysis) had to receive different treatment because where large discrepancies could be observed between actual prices and so called intrinsic value, their exploitation is not ruled out per se by the Random Walk Hypothesis. In theory, large number of stockbroker analysts with keen eyes would help to quickly dispel any discrepancies in the market thereby making it efficient. In practice, they should consistently outperform, after fees, a random portfolio of assets with the same riskiness and be capable of being tested for the same. No one has so far come forward for such a test but collective investment funds may be regarded as a good substitute for analysts or stockbrokers. No study has so far been able to indicate that after account is
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Sapienter

Wealth Management is a trading style of Peter A Sudlow Certified Financial PlannerCM which is Authorised and Regulated by the Financial Services Authority

Sapienter Wealth Management

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taken of the risks run, a collective fund produces by skill returns which are in excess of the market. Some evidence of bad performance persists in funds. These studies hold true for both the UK and the US. Development of Random Walks since then has gone in the direction of the Efficient Market Hypothesis which is more a model of how markets operate and prices reach equilibrium, i.e. where supply is equal to demand. Stated simply it says that a market is said to be efficient if prices in that market reflect all available information instantaneously. In 1970 Famas paper Efficient Capital Markets: a review of theory and empirical work, sought to lay down tests for the hypothesis. A market had weak efficiency if prices fully reflect any information contained in past data. A market had semi-strong efficiency if prices reflected all readily available public information. A market had strong efficiency if prices reflected all public and privileged information. Strong efficiency is regarded as unobtainable. The review confirmed from empirical data that the model stood up well to tests (R 2 of 90%) and had few exceptions. The apparent exceptions have since been identified as three: insider trading, momentum & post earnings notification where some price persistency occurs. In 1992 collating research done by others, Fama together with Ken French observed that a stocks Beta was incomplete in explaining its return. The advent of more data had meant the conditions for the Capital Asset Pricing Model of Sharpe, Lintner and Black had broken down. Instead, using others empirically observed anomalies, Fama and French showed how two other variables i.e. a stocks Size in relation to other stocks and its book-to-market Value, explained more fully the (cross section of) returns from stock markets around the world and over different time periods. A recent objection from behavioural finance describes many investors and professionals as irrational, acting through greed or fear, and thereby making markets less efficient. Market participants, whatever their motivation still act rationally i.e. in consideration of their objectives, unlike animals who act by instinct. For markets to remain efficient, this consideration only has to be observable in prices. A leading exponent of behavioural finance Richard Thaler concedes that if inefficiencies do exist, in his opinion they are not exploitable for profit and the Hypothesis is thereby strengthened. What then is the sum total of wisdom for investors to practise from discussion about Efficient Markets, Random Walks and Three Factors in order to invest well? The best way for an investor to obtain returns is to: Hold a market diversified portfolio Having exposure to the three factors of risk: the market, small and value companies With a home country bias of 50% To use short dated international bonds to reduce volatility To set asset allocation as a proxy for the level of risk To use a buy and hold strategy To use lowest cost vehicles of a collective character Ignore anomalies where after transactions costs no improvement is available to an investor
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Sapienter

Wealth Management is a trading style of Peter A Sudlow Certified Financial PlannerCM which is Authorised and Regulated by the Financial Services Authority