Free Markets: Information, Prices, Risk and Return
EMH = Efficient markets hypothesis
See [broken link removed] for more
Active*investors in contrast to passive investors believe that they can beat the market. To beat the market without accepting more risk is possible only if you posses information that is not known to the market. It must be information that only you or a small group of investors are aware of. As a result, all active investors or traders should ask themselves these questions before trading:
Why wouldn’t this information already be embedded in the price?
Is this inside information or is it information that is well known to all investors?
Is there a convincing reason to assume that the current price is unfair?
The vast majority of investors trade on publicly known information (earnings forecast, revenues forecast, expected resignation of a CEO, past price trends etc.) that is already incorporated in the prices of publicly traded securities. *Therefore, there is no convincing reason to assume that current prices are not fair.
If you are buying stocks of a certain company to speculate on any information how can you be sure that the guy selling the stock to you does not have better information? If he is selling why are you buying? If the guy selling the stocks is an experienced investor or a mutual fund manager, are you really sure that you posses more valuable information than these highly educated people?
In conversation with Eugene F Fama, economist at the university of Chicago and father of the efficient markets hypothesis.
Others: The concept of what is fair pricing of stocks and securities and the interpretation of what the efficient markets means for fair prices is quite an interesting discussion…
Eugene F Fama: Prices at any point in time fully reflect all of the information that is available at that time-which means whatever can be predicted about the future based on available information.
Others: This information flow is a very, very, very complex network of human behavior, data invention, mistakes….
Efficient market theory does not say that markets are perfect… every price could be wrong, …but those errors are random.
The reason prices are fair is because they are not predictable…in other words if there was an easy way to game on all that, they wouldn’t be fair…
Q. In the last 12-months we have seen very volatile period in the markets-it is not the first time, we have had a lot of people out there saying and this proves that the Efficient Market Hypothesis (EMH) is dead-what do you say to those people?
A. Well, there is a more general challenge today to market per se; I mean this kind of economic event brings out the woodwork of the people who never thought markets were not worth anything anyway. I don’t mean just academics but people who in general are very suspicious of market allocations of resources-tend to jump in when things like this happen
…But as far as I am concerned the increase in volatility was to be expected given the degree of increase in economic uncertainties-looks like things are looking a little better now-but a very few months ago people were talking about something akin to the Great Depression-which was a period of incredible economic uncertainty and very depressed economic activity which indeed merited a very large decline in prices from 1929 to 1932-much larger than what we have seen this time…now if there is a little rebound in prices then I think that is a judgment by investors who after all determine prices- that things may be not as bad as they first looked…
…But the market can only know what’s knowable-it can’t resolve uncertainties that are unresolvable-so when there is a large amount of economic uncertainty out there…there is going to be a large amount of volatility in prices and that’s what we have been through-as far as I am concerned that is exactly what you would expect an efficient market to look like-the fact that prices went down says two things-expected profitability went way down and in addition people probably became more risk averse-so the premiums they probably required to hold stocks went up-in this period of time-but that is very consistent with an efficient market.
Q. So very simply the fact that market at any time does not anticipate what is going to happen next-does not mean that it is inefficient!
A. No, of course not then there would be no uncertainty about the future.
Q. Ok, so the implications are, still notwithstanding what has happened in the last year that for the average investor, in order to achieve or go for a higher expected return, the more sensible thing to do is to have a diversified portfolio -but to increase or reduce the risk according to the level of appetite.
A. That’s exactly right. I don’t know of any empirical evidence that goes against that-in fact if you look at the people-the behavioural finance people for example- go on and on about inefficient markets-and at the end they will say-but of course it is so difficult to say where the inefficiencies are-you are better off buying passive products and just do a risk-return trade off-and at that point I sit up and say-if markets were really as inefficient as we were talking about-I think you would be better identifying these inefficiencies in some practical way that investors could use-but they generally punt on that one at the end.
Q. So you do not discount the possibility that there are investors out there who do achieve better returns than the market?
A. What does the evidence say? ‘Insiders’ do better in their own stocks-as far as they trade in their own company stocks they do better, but they do better only by a bit as it turns out. So the market is not efficient as far as the insiders of a company are concerned-at least the top insiders.
…So it (the market) is not efficient at every level but for practical investment purposes, of almost everybody I can think of, including myself, it (the market) is EFFICIENT.
Q. What’s the most potent challenge that you have ever had from another academic to the EMH?
A. Well there is evidence that there is somewhat more momentum in stock returns that can’t easily be explained by a risk theory-that gives me a little trouble…then there is another one that says that the market returns following earnings announcements tend to persist a little more than you would expect if the markets were completely efficient-but neither of these present a lot of opportunity on which a lot of money can be made-because it involves so much trading and trading costs…but as far as I know those two are the biggest contradictions or potentially biggest contradictions of market efficiency…
…So you have to realize that market efficiency is a model-which means it is a simplification of the world,-which does a good job on almost everything-but there are some things on which it doesn’t do a good job-so insider trading would be one, there is momentum phenomenon is another one, and maybe this post earnings is another one…
…But they are few and far between, these things, and for practical investment purposes, the market is efficient for pretty much everybody.
Q. So if I can sum up in layman’s terms-what you are saying is that EMH is not a perfect explanation of everything that happens in the markets-but it is the best working proposition for use by investors in a practical sense-that most investors should presume that the only way in which they can reliably effect the expected return from their portfolios is by verifying the level of risk they are prepared to take.
A. Absolutely true.
Q. And nothing that has happened in the last 12 months that has altered that in any way?
A. No, I don’t see any informed opinion to the contrary on that. There are some people claiming that markets are not efficient-but they are not claiming there are easy profit opportunities out there, which seems like a conflict to me – it is either one or the other.
EMH = Efficient markets hypothesis
See [broken link removed] for more
Active*investors in contrast to passive investors believe that they can beat the market. To beat the market without accepting more risk is possible only if you posses information that is not known to the market. It must be information that only you or a small group of investors are aware of. As a result, all active investors or traders should ask themselves these questions before trading:
Why wouldn’t this information already be embedded in the price?
Is this inside information or is it information that is well known to all investors?
Is there a convincing reason to assume that the current price is unfair?
The vast majority of investors trade on publicly known information (earnings forecast, revenues forecast, expected resignation of a CEO, past price trends etc.) that is already incorporated in the prices of publicly traded securities. *Therefore, there is no convincing reason to assume that current prices are not fair.
If you are buying stocks of a certain company to speculate on any information how can you be sure that the guy selling the stock to you does not have better information? If he is selling why are you buying? If the guy selling the stocks is an experienced investor or a mutual fund manager, are you really sure that you posses more valuable information than these highly educated people?
In conversation with Eugene F Fama, economist at the university of Chicago and father of the efficient markets hypothesis.
Others: The concept of what is fair pricing of stocks and securities and the interpretation of what the efficient markets means for fair prices is quite an interesting discussion…
Eugene F Fama: Prices at any point in time fully reflect all of the information that is available at that time-which means whatever can be predicted about the future based on available information.
Others: This information flow is a very, very, very complex network of human behavior, data invention, mistakes….
Efficient market theory does not say that markets are perfect… every price could be wrong, …but those errors are random.
The reason prices are fair is because they are not predictable…in other words if there was an easy way to game on all that, they wouldn’t be fair…
Q. In the last 12-months we have seen very volatile period in the markets-it is not the first time, we have had a lot of people out there saying and this proves that the Efficient Market Hypothesis (EMH) is dead-what do you say to those people?
A. Well, there is a more general challenge today to market per se; I mean this kind of economic event brings out the woodwork of the people who never thought markets were not worth anything anyway. I don’t mean just academics but people who in general are very suspicious of market allocations of resources-tend to jump in when things like this happen
…But as far as I am concerned the increase in volatility was to be expected given the degree of increase in economic uncertainties-looks like things are looking a little better now-but a very few months ago people were talking about something akin to the Great Depression-which was a period of incredible economic uncertainty and very depressed economic activity which indeed merited a very large decline in prices from 1929 to 1932-much larger than what we have seen this time…now if there is a little rebound in prices then I think that is a judgment by investors who after all determine prices- that things may be not as bad as they first looked…
…But the market can only know what’s knowable-it can’t resolve uncertainties that are unresolvable-so when there is a large amount of economic uncertainty out there…there is going to be a large amount of volatility in prices and that’s what we have been through-as far as I am concerned that is exactly what you would expect an efficient market to look like-the fact that prices went down says two things-expected profitability went way down and in addition people probably became more risk averse-so the premiums they probably required to hold stocks went up-in this period of time-but that is very consistent with an efficient market.
Q. So very simply the fact that market at any time does not anticipate what is going to happen next-does not mean that it is inefficient!
A. No, of course not then there would be no uncertainty about the future.
Q. Ok, so the implications are, still notwithstanding what has happened in the last year that for the average investor, in order to achieve or go for a higher expected return, the more sensible thing to do is to have a diversified portfolio -but to increase or reduce the risk according to the level of appetite.
A. That’s exactly right. I don’t know of any empirical evidence that goes against that-in fact if you look at the people-the behavioural finance people for example- go on and on about inefficient markets-and at the end they will say-but of course it is so difficult to say where the inefficiencies are-you are better off buying passive products and just do a risk-return trade off-and at that point I sit up and say-if markets were really as inefficient as we were talking about-I think you would be better identifying these inefficiencies in some practical way that investors could use-but they generally punt on that one at the end.
Q. So you do not discount the possibility that there are investors out there who do achieve better returns than the market?
A. What does the evidence say? ‘Insiders’ do better in their own stocks-as far as they trade in their own company stocks they do better, but they do better only by a bit as it turns out. So the market is not efficient as far as the insiders of a company are concerned-at least the top insiders.
…So it (the market) is not efficient at every level but for practical investment purposes, of almost everybody I can think of, including myself, it (the market) is EFFICIENT.
Q. What’s the most potent challenge that you have ever had from another academic to the EMH?
A. Well there is evidence that there is somewhat more momentum in stock returns that can’t easily be explained by a risk theory-that gives me a little trouble…then there is another one that says that the market returns following earnings announcements tend to persist a little more than you would expect if the markets were completely efficient-but neither of these present a lot of opportunity on which a lot of money can be made-because it involves so much trading and trading costs…but as far as I know those two are the biggest contradictions or potentially biggest contradictions of market efficiency…
…So you have to realize that market efficiency is a model-which means it is a simplification of the world,-which does a good job on almost everything-but there are some things on which it doesn’t do a good job-so insider trading would be one, there is momentum phenomenon is another one, and maybe this post earnings is another one…
…But they are few and far between, these things, and for practical investment purposes, the market is efficient for pretty much everybody.
Q. So if I can sum up in layman’s terms-what you are saying is that EMH is not a perfect explanation of everything that happens in the markets-but it is the best working proposition for use by investors in a practical sense-that most investors should presume that the only way in which they can reliably effect the expected return from their portfolios is by verifying the level of risk they are prepared to take.
A. Absolutely true.
Q. And nothing that has happened in the last 12 months that has altered that in any way?
A. No, I don’t see any informed opinion to the contrary on that. There are some people claiming that markets are not efficient-but they are not claiming there are easy profit opportunities out there, which seems like a conflict to me – it is either one or the other.