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 September 2005 Efficient Markets, Inefficient Investors
The SEC's Regulation FD has further leveled the playing field for professional as well as individual investors. Companies can no longer provide material information to selected analysts without simultaneously making it available to the investing public. While there's no question that information is flowing more quickly and freely than ten or fifteen years ago, its impact is less certain. Has it really made us better investors? People did their research on the internet before buying hot stocks at their peak in the equity bubble. After watching CNBC all day, they sold at the bottom in the subsequent bear market. Now they're all parties to class action lawsuits blaming conflicted analysts for providing timely but misleading information. The value of information lies in how you use it. Looking back over the past fifteen or so years, it doesn't appear that it's been used very well. So much so, it's tempting to say market efficiency may be suffering. That, however, opens up a totally different can of worms. One Word, Many FactorsWhen people are buying high and selling low, it's hard to think of that as efficient. When analysts' recommendations are based more on the benefits to themselves rather than the value of the security in question, that doesn't seem very efficient, either. But in the investing world, 'efficiency' means something else.A capital market is said to be informationally efficient if security prices rapidly adjust to new information. Under these circumstances, security prices always reflect all available information. To a certain extent, this relies upon the actual mechanics of the market rather than actions of individual investors. For example, back in the days of ticker tapes and telegraphs, information didn't flow as quickly nor was it assimilated as rapidly as today. Now, with electronic posting of almost every trade, information travels much faster and is more accessible to a wider audience.
The mechanisms and technology underlying the capital markets have dramatically improved over the years. Although today's markets aren't totally informationally efficient, they are much more so than even several years ago. But remember, it's not just access to information that's important, efficiency is also dependent on how this information is used. The rapid and accurate flow of information is essential, but this data must also be correctly reflected in security prices for the overall market to be considered efficient. That's where individual investors come in. For a market to be efficient, three things must consistently occur:
The first condition simply describes a free and open market like those of the U.S. and Europe. Investors are assumed to be rational profit-seekers. This doesn't mean they always make logical decisions (more about this a little later), but rather that no one deliberately sets out to lose money. Investors are assumed to analyze and value securities to determine what they feel is a fair price. This certainly doesn't mean they all pore over complex spreadsheets full of arcane statistics and ratios, but only that they have some basis for they buy or sell decisions -- perhaps even as flimsy as an analyst's recommendation. The second assumption infers that information flows in a random fashion. To be sure, most corporate profits are reported in the third and fourth week of each quarter, but even then one company's isn't directly related to another's. New information enters the market as it occurs without any overarching pattern or relation to anything else.
Under the third assumption, all market participants act on new information as rapidly as possible. Each wants to be sure his or her analysis quickly reflects all available data in order to prevent valuation and trading errors. After all, if everyone else adjusts their valuations and you don't, you run the risk of ending up on the wrong side of the trade. If all these conditions are satisfied, then information flows into the market as it occurs. Market participants quickly adjust their analysis and securities almost immediately reflect this new data. As a result, security prices always fully reflect all available information. It's important to realize that even in an efficient market, investors are still human. Although under the third assumption investors attempt to adapt their valuations as quickly as possible, not all will be successful. Some will over-adjust either up or down. Everyone won't arrive at the same price -- otherwise, there'd be no trading. The technological improvements of the past few decades have greatly increased the flow of information. Informational efficiency has thereby increased and perhaps overall market efficiency has, too. But are the markets truly efficient? If so, how do you account for the wackiness of the 1990's equity bubble? Implications of EfficiencyAlmost everyone has access to the same information now. Individual investors may have to look a little harder to find it and they may get it a little later than professionals, but the gap has closed dramatically from only a few years ago. With the possible exception of inside information, everyone is roughly on the same footing.As a result, superior investing results can't be derived from historical or even current information. If everyone has the same information at roughly the same time, the mere possession doesn't lead to exceptional returns. Again, it's not the information itself, it's what you do with it. The most successful investors are the ones who are best at predicting future market movements, yet in an efficient market, many commonly used techniques won't work. For example, technical analysis based on charts and historical pricing patterns would be virtually useless. Trading rules based on buying or selling when a security moves by a specified percentage would be equally futile. Fundamental analysis comparing a stock's current ratios or financial factors to historical norms should also fail. Statistical studies over the past 15 years also indicate that trading based on observed anomalies such as the January Effect or events like stock splits or IPOs are not reliable predictors over the long-term.
This could go a long way toward explaining why without resorting to trickery, most professional money managers fail to surpass their benchmarks. Most adhere to a combination of these technical or fundamental techniques. If they won't work in an efficient market, they won't work for professionals, either. As mutual fund prospectuses point out, historical results are no guarantee of future performance. The superior investor is the one who is able to successfully predict future security price movements without relying exclusively on previous trends or fundamental patterns. That's certainly easier said than done. As a result, investors shouldn't make risky bets in an effort to beat the market. Diversification and asset allocation should be the primary focus. Investors should focus on what they can control: expenses. By controlling turnover and transaction costs, net returns can be increased. Index funds and Exchange Traded Funds (ETFs) can help in this regard. In addition, realized taxable gains should be timed to minimize their impact. Bubbles and TiersUnfortunately, most investors -- professional as well as individual -- don't follow these guidelines. They think their analysis and research provides some insights others lack. Armed with this "information" they expect superior results. If they do outperform in an efficient market, it's more the result of luck than skill.Did the equity bubble show the market wasn't efficient? Absolutely not. Everyone -- including those chasing the hottest new IPOs -- were attempting to price securities based on the same, almost simultaneously available information. Indeed, the internet and 24-hour financial cable channels helped make this data available to all. This increased flow of information also encouraged investors to focus on the short-term. Instead of viewing stocks as long-term investments, they were seen as trading vehicles. Companies weren't assessed for their long-term potential but rather by each earnings release on a quarterly basis.
When internet stocks with no earnings were changing hands at triple digit prices, the market was still efficient. It was equally so when the bubble popped and they traded in single digits or even went out of business. Does that seem odd? It shouldn't if you recall there's a difference between having information and using it. When internet stocks were soaring, investors believed -- based on the data they had -- that this was the beginning of the "New Economy". The internet and companies that used it were set to lead us to the next level. Even analysts who didn't suffer from investment banking conflicts of interest put high prices on their shares. Each quarterly earnings -- or more precisely pro-forma earnings -- release sent investors scrambling to analyze the results and come up with new valuations. It was informationally efficient. But as investors painfully learned in the bear market which followed, prices set in an informationally efficient market aren't necessarily reflective of intrinsic value. As long as they labored under the misconception that earnings didn't matter in the New Economy, investors used the information that was available to assign astronomical values to stocks with intrinsically little or no value. When it became obvious that earnings did matter, investors priced them accordingly. Consistency is perhaps the one aspect in which professional investors differ from individuals. The best professionals are the ones who are willing to stick with their convictions in turbulent markets. Individuals (and poorer professionals) are less likely to stay the course and are more prone to shift strategies when the market moves against them. This is often a recipe for failure. Again the equity bubble of the 1990s provides a good example. Everyone became risk seekers, willing to pile into internet and technology stocks. Diversification and asset allocation went out the window because they appeared to not be working over the short-term.
Value managers, those who maintained diversified equity portfolios, and those who continued to allocate funds to fixed income quickly fell by the wayside. However, when the equity bubble burst, they emerged as the real winners. Not only did they reap superior returns in the bear market, they also ended up with better results over the 5 and 10 year periods encompassing the late 1990s. This, along with day-to-day trading action, suggests there are two tiers to the market. The first is composed of professionals who use all available information to map their strategies and set their course for the long-term. They do their homework and anticipate many of the coming earnings surprises and corporate actions. The more accurately they can make these predictions, the better their results. Individuals and less seasoned professionals form the second tier. They have the same information available to them as the first tier, but they often lack the ability to interpret it as accurately. They're frequently caught off guard by negative earnings surprises or merger announcements. When such news does come out, they may sell reflexively, adding short-term volatility to the market. This behavior is particularly evident in the first few weeks of each quarter as the prior quarter's earnings are reported. Shares often sell off sharply on the day of the announcement if a firm falls short of analysts' estimates. We'd suggest this is the result of second tier investors assimilating this information. Yet shares often recover almost as dramatically the day after the announcement. We'd suggest this is the result of first tier investors purchasing shares at the prior day's discounted price. In Wall Street parlance, this is "stocks leaving weak hands for strong hands". Why does this occur? It's market efficiency again. If tier one investors had correctly valued the stock -- including the anticipated earnings miss -- the day before the announcement, the resulting sell-off after the announcement sent shares to discounted (or undervalued) levels. When tier one investors step back in to purchase shares, they're taking advantage of this discount. The fact that opportunities like this can occur doesn't mean the market itself is inefficient, only that a substantial subset of investors is. As long as investors are human, there will be trading opportunities like this. That's why there's also a place for technical analysis. Unlike fundamental analysis which focuses on the financial characteristics of companies, technical analysis is based on supply and demand in the market which, to a great extent, is often determined by less than rational human choices. Technical analysis has always had an element of what's now called "behavioral investing" and as long as it does, it will serve a useful function. Market efficiency has improved over the past 10-15 years, but by itself it can't make us better investors. That can only happen if we recognize what this means and act appropriately on the additional information it provides. It's not the amount of information you have, but what you do with it. Search this site! Just enter you key word or words:
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