Tuesday, 26 January 2010

Market Efficiency: Implications for the Individual Investor

How many times have you read that the stock market is efficient and that therefore you cannot beat the market? What do such statements mean and what are the investing lessons for the individual?

Academic researchers, beginning with Eugene Fama in the mid 1960s, set out the Efficient Market Hypothesis as the notion that stock prices at any moment reflect all available information. The information can include, first, past stock prices, second, all publicly available published data such as accounting reports, analyst reports, news, economic forecasts or anything else that might affect the price, and third, all insider information known only to company executives. The hypothesis states that prices adjust instantly when new information comes out. Since new information is unpredictable, prices are as likely to go down as up, leading to the oft-seen statement that prices follow a random walk.

The conclusion drawn by many is that trying to find winners by active stock picking is a lost cause and the individual investor should simply buy and hold passive index funds. Passive index investing through ETFs or mutual funds is certainly one viable course of action, especially for those who want to spend little time and effort and are content with average market returns, which are usually positive over the long run, though not perhaps in any given year e.g. 2008!

Is there no further possibility? Many believe incorrectly that there is no hope for any investor to outperform the market and that prices are as correct as they can be at any moment. But there is hope and to see why, the key is to understand that efficient markets do not imply that all stocks are correctly valued at all times. Efficient markets only require that prices be fair and unbiased, meaning that they are as likely to be too high as too low. Prices can also deviate enormously from true values. The very mechanism that brings about market efficiency is the action of investors in detecting bargains and investing in schemes to profit. Inefficiencies and mis-pricing are constantly springing up to be devoured and eliminated by investors.

It is best to measure how efficient markets are (and different markets like the NYSE and the TSX are likely to vary in efficiency), and not say that they are black or white efficient or inefficient. A neat summary of Market Efficiency by NYU finance professor Aswath Damodaran tells us the key features that contribute to efficiency - more accessible, reliable and voluminous information; lower transaction costs, higher liquidity and trading volumes, practicality of trading. The opposite conditions mean inefficiency that can be exploited for profit.

Research tests of market efficiency have also uncovered several anomalies: small firm stock returns outperform those of large firms in January; less liquid / less traded stocks and those not widely held by large institutional investors outperform their opposites (which more or less equates to small firms); firms with low accounting book-to-market ratios outperform. Such anomalies signal possible investing strategies for the individual, even allowing that markets have a high degree of efficiency.

Widely followed, highly visible large companies on major exchanges are unlikely
to give the individual investor the best opportunities to make significant excess profits. Instead, the best place to search is amongst the neglected, the less-known where there are fewer of the highly skilled professional institutional investors against whom the individual investor must compete.

Efficient Market Implications:
1) Best Investing Possibilities for Outperformance by the Individual Investor
  • smaller companies - do a sort by market cap size and pick the low end
  • companies with little or no analyst following - most discount brokers show analyst ratings so focus on companies with no ratings
  • companies with low trading volume - check the trading volume on the market info about a stock
  • January - do your buying then, especially at the beginning of the month
  • companies with low book-to-market ratios - this does not mean every such company will experience good returns, many are real dogs
  • emerging markets - where information is harder to obtain
  • what you know - popularized by Peter Lynch in his classic book One Up on Wall Street, the idea is that the average person may be able to have an information advantage over even the pros in a specific sector or about a specific company
2) Where Outperformance is Unlikely
  • technical analysis and the detection of patterns in stock price movements alone has, unfortunately, never proved successful in any proper examination so this is likely not a good method to look for excess returns
  • large companies in highly efficient markets of developed countries - USA, Europe, Canada; passive index funds are a surer route
  • one stock only is very risky; diversify - even the best stock pickers amongst the professionals have some losers amongst their big winners so it is unwise just to have one or two holdings; against this is the fact that in-depth knowledge becomes impossible with dozens of holdings. It is a trade-off and there is no perfect guide.
The suggestion that the above areas are the more promising does not mean that automatically any such stock is a good buy. The due diligence collection and analysis of information is essential to realizing those better odds.

Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations.

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