Richard Beddard’s extensive comments on my last post on efficient markets deserve a full reply. He is correct that I did not make it clear that the paper says that a behavioural explanation of the abnormal returns is possible.
Although the paper suggests further research to determine whether Grossman and Stiglitz’s rational market explanation, or the behavioural explanation is correct, it also says:
Behavioral explanations, such as over/under reaction of investors, are also plausible, however I am not aware of any behavioral model that specifically predicts the pattern I observe in returns.
So, Grossman and Stiglitz predicted the results, but no behavioural model (as far as we know) did. So although the behavioural models may still be plausible, the rational markets models are doing better so far.
While we are on the subject of behavioural finance, the paper also says:
More generally, lower returns after a month of “good” news, does not support the common behavioral argument that investors are slow to react to news.
Moving on to Richard’s comment on markets being “imperfectly efficient”. I am happy to go along with that: nothing in this world is perfect. I mentioned arbitrage opportunities in the previous post. One of the commonest assumptions made by financial theory is that arbitrage opportunities cannot exist. The reason for this is that as soon as one appears traders will exploit it, and in doing so will move prices to remove it. So arbitrage opportunities are almost always small and transient.
Because of this we can assume that the correct price of securities will be one that does not all arbitrage opportunities (so we can assume no arbitrage in pricing models), and very few investors look for arbitrage opportunities (those that do are mostly proprietary traders and hedge funds).
Something similar happens in the process by which the market sets securities prices. Active investors adjust what they are willing to pay in response to news. Those who react fast and accurately can make an abnormal return, but by doing so they adjust the price: for example, if there is good news in the annual results that needs some effort to understand, the investors who realise it first will start buying, and the increased demand will push up the price. Other investors will catch on, and the market at large will absorb the good news, but by then the price will reflect the news.
Richard also raises the question of the cost of the analysis necessary to find the inefficiencies. That takes us back to Grossman and Stiglitz. There 1980 paper says:
We propose here a model in which there is an equilibrium degree of disequilibrium: prices reflect the information of informed individuals (arbitrageurs) but only partially, so that those who expend resources to obtain information do receive compensation.
In other words, the market is inefficient enough to make research profitable enough that people will do it, but no more.
This is very elegant and explains why small companies are more likely to be mispriced: the total profit on an equal percentage mispricing is smaller, so the percentage needs to be greater in order to compensate the equal amount of analysis. I wonder whether this is partially offset by a greater mispricing in the prices of companies that are hard to understand.
This really is a ‘glass half full/glass half empty’ situation. I’d argue the market is just inefficient enough to allow investors to make excess returns out of it. Which is the same thing.
But I think this anlaysis ignores the main mechanism, i.e. the value premium. I think the paper does too (from memory he rebalanced the portfolios he tested every month, which doesn’t give much time for value to out).
As well as the short-term arbitrage opportunities you mention there are also the long-term mispricings that occur in bubbbles. AS we’ve discussed before the reason for them is most probably behavioural in the tendency of institutional investors to herd.
I agree that there is evidence that value tends to out-perform.
However, what I think this tells us is not that institutional investors herd, but that they gamble with our money. They are not risk averse enough, so risky growth shares are over-valued.
The market is very efficiently reflecting the fact that some investors like risk!
Well I think that’s the same thing to. Why do they gamble with our money? Why do they take such risks? Because the greater risk is losing their job or their clients by underperforming in the short term. Since that creates mispricing, it looks a lot like an inefficiency.
If the market is efficient when it reflects things that look like inefficiencies then the emh looks a lot like a tautology.
If people were more risk averse, risky shares would be cheaper.
If people were less risk averse, risky shares would be cheaper.
If people were gamblers, risky shares would be cheaper than lower risk shares.
Investors, in aggregate, are gamblers – at least to a sufficient extent to over pay more for growth than a risk averse/CAPM using investor would.
I am not sure its just institutions: a lot of private investors are willing to gamble a fair bit: that’s why all those tip sheets pushing small cap growth shares have readers.
EMH still have value, as a building block for other financial theories. We may throw out MPT, but its likely that its successor will also depend on EMH.