Are markets efficient?
A finance professor and his student were walking across campus when they spotted a $20 bill on the ground. The professor advised, “Don’t bother picking that up. If it was real, someone would’ve picked it up already.” The student picks it up anyways and buys himself to a beer.
There are not a lot of $20 bills laying on the ground, but they are found from time to time. That’s the short answer. The long answer is as follows:
The term efficiency is used to connote several different ideas, but the most common one is a concept formalized into the Efficient Markets Hypothesis (EMH) by Eugene Fama, who won a Nobel prize for his work on the subject. The theory basically says that markets allocate capital best and thus value assets best (or “efficiently”). There are 3 forms of the theory:
- Weak Form: all historical information is priced into an asset’s price.
- Semi-Strong Form: all historical and public information is incorporated into an asset’s price.
- Strong Form: all historical, public, and non-public information is Incorporated into an asset’s price.
However, below are some instances when when each of the forms does not hold up.
- Prices often have material and sustained moves when private information is publicized.
- Prices often move on earnings announcements or press releases.
- The uncovering of scandals or fraud impacts prices.
- I do not know anyone that subscribes to the strong form of the EMH.
- Arbitrage opportunities exist fairly frequently. Although not all are actionable due to constraints and costs, enough are:
- Closed-end funds can trade at extreme premiums and discounts to their underlying NAV.
- We have seen public companies trading for less than the value of their stakes in other public companies.
- Momentum as a risk factor has been shown to offer a return premium.
- Flash crashes and flash rallies have extreme mean reverting tendencies.
Beyond poking holes in the idea of market efficiency, the above examples represent opportunities for active managers to outperform. Yet, it is difficult for investors to outperform on a consistent basis, which implies (but does not prove) that markets are at least somewhat efficient.
So what can we conclude? That markets are not always efficient, but are probably efficient at least some of the time. This is a very unsatisfying answer, but that is okay because it is unclear whether market efficiency even matters to investors. I’ll explain why in an upcoming post.
P.S. My own view is that markets are generally efficient, although this cannot be proven. I could’ve listed more examples of market inefficiency, but they would not have been robust enough to categorically prove markets are inefficient and stand up to every possible logical critique. On the other hand, data showing that markets are difficult to beat does not prove markets are efficient, but it seems like investors would beat the markets more easily, frequently, and consistently if markets were generally inefficient.
Thus, I believe markets are generally efficient. However, efficiency seems non-existent during certain times (ie. when rationality gets thrown out the window during bubbles and panics) and in specific asset classes (where there are constraints to arbitrage, complexity, due diligence costs, transaction costs, or anything else that makes it difficult to invest easily). So my usual answer to the original question is that markets are generally efficient, but there are episodes and pockets of inefficiency.