The ‘Efficient Market Hypothesis’ and ‘Market Anomalies’

10th Jan '22 by Gilgamesh_Investor

5 comments 997 reads

I would be very interested to discuss the theory of the ‘Efficient Market Hypothesis’ and ‘Market Anomalies’ here.

I am hopeful that this thread will create thought provoking content for both experienced and novice private investors as it is always good to reflect on our investment style alongside learning and educating. I am a novice myself and just learning from textbooks and the seldom bit of wisdom that one supplies from experience.

The Efficient-Market Hypothesis:

The efficient market hypothesis (EMH) theory states that a financial asset reflects all of the available information to the market. It assumes that it is ‘impossible’ to ‘beat the market’ consistently on a risk-adjusted basis, since the market price should only react to new information.

The Weak-Efficient Market Hypothesis?

The weak efficient market hypothesis is an adaptation which states that the price of the market is correct when taking into account past financial prices. This assumes that past and current financial prices are reflected in the market, but future prices are not, even if this information is available to the market.

The Semi-Stong Efficient Market Hypothesis’?

The semi-strong efficient market hypothesis assumes that current market prices reflect all publicly available material information but does not take into account private information which is publicly traded.

The Strong-Efficient Market Hypothesis’?

The strong efficient market hypothesis incorporates the idea that the current market reflects all material information, whether this be available publicly or private.

Market Anomalies:

Secondly, I would like to draw onto the topic of market anomalies and what peoples views are on them? - Do they use them to profit from them or is it all taken into consideration in the efficient-market hypothesis?

1. Examples of market anomalies include;

2. The January Effect

3. Book to market effect

4. Neglected stocks

5. The halloween effect

6. Sell in May and go away

7. Closed-end fund discount

8. Post Earnings announcement drift

9. IPO Effect

Personal Viewpoint:

I suppose my personal view is that the market is semi-strong, indicating that private information, that is information obtained via the process of thorough due diligence and analysis, can provide market beating opportunities, but the timing of these market opportunities is down to a combination of luck, emotion and patience.

In addition to this, time is…

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welwichia

11th Jan '22

Hi Gilgamesh_Investor,

thanks for a thoughtful post. There is a quote from Buffet that succinctly sums up my thinking:

“Observing correctly that the market was frequently efficient, they [academics, investment professionals and corporate managers] went on to conclude incorrectly that it was always efficient. The difference between the propositions is night and day.”

However, I think the trap for many of us is to then fall under the spell of thinking that making lots of money in the stock market is somehow easy. The reality is that there are armies of incredibly talented and highly incentivised people, supported by vast research and analysis budgets all fiercely competing with each other to try and gain a small edge. Additionally, they have access (sometimes even privileged) to corporate insiders that small private investors will never have.

At the same time it is also really difficult in this game to disentangle skill from luck - especially in times of artificial liquidity driven "everything rallies" like we seem to be in the middle of now. Am I really any good as an investor or have I just benefitted from the rising tide that is lifting all boats?

So for me personally I have found that guarding against a sense of over-confidence and hubris is the number one challenge to constantly be on the look out for. What I have found helpful:

- picking my spots and being very clear about where I think I can add some value. To my mind, the probability of me gaining some exploitable insight into e.g. Microsoft or Unilever that the market is somehow "overlooking" is simply zero. So for that area of the market I gain exposure via collectives like Investment Trusts and ETFs. On the other hand, I think there are areas of the market we can have an advantage as private investors - e.g. less covered small caps where liquidity and market cap restrictions make it less viable for the institutions to play. The other great advantage is that with no outside investors, I have complete flexibility in how and when I chose to invest ... if I feel that I am not being adequately compensated for bearing risk, I can sit and wait in cash and don't have to answer to anyone.

- being ruthlessly honest about returns (after costs!). This requires good record keeping and accurate calculation of returns (arithmetic vs geometric averages, time-weighted vs dollar-weighted etc) to make comparisons meaningful. I want to be able to confidently answer the question: "What would have happened if I had chucked it all into e.g. £VWRL ?). I try to be really disciplined about this - the "uncomfortable truths" that hard numbers provide are a good antidote to our natural proclivity to getting swept up in promising stories and wishful thinking.

Finally, I think it also helps to think about what one's portfolio is ultimately for - e.g. living off the investments means periodically having to generate cashflows from the underlying assets. There are some areas of the market that I just don't find very interesting (or understand sufficiently well) so don't want to constantly have to make lots of decisions about; again I find it easier and more convenient to outsource this to a collective vehicle (IT/ETF) to manage for me. This angle obviously depends on individual time horizons and where one is in one's life journey.

Anyway, long rambling post - looking forward to further discussion and insights from others!

Best Wishes,
welwichia

DWit199

I think the five most recognised factors (anomalies) are value, momentum, size, quality and volatility. There are many different definitions of each but all are easily accessed in some form or other within Stockopedia.

Should we try to bring all of those factors together in the individual share selections and just run a single large "factor" portfolio or should we separate the factors into several discrete portfolios? I favour the former and have a single large portfolio where shares are selected depending upon a combination of the five factors. In the NAPS Ed has effectively chosen the latter by having two portfolios, one QM the other VM.

DavidMcCabe

12th Jan '22

This makes a huge amount of sense!

HHR

13th Jan '22

Thanks for the post! And thanks too to welwichia who has covered a lot of what I would say.

Efficient Market Hypothesis

If the academics who supported EMH in the 60’s had merely proposed it as a framework for modelling and understanding markets then I think investors would have welcomed that as a useful contribution.

But they went a step further in the assertion that because participants price information flows efficiently, it therefore follows that it’s impossible to beat the market. That was a bit of a red rag to a bull!

My opinion

It seems to me that in making the above assertion EMH relies on a couple of obviously imperfect assumptions; i) participants act rationally, ii) all information is immediately available to all participants. These two imperfect assumptions, together with the demonstrable ability of a minority of investors to consistently beat the market over timespans of decades undermine the theory that you can’t beat the market.

That said, one of my investment mistakes is over confidence in my own ability to out-think the market so I constantly try to remind myself to respect the market’s opinion (e.g. sell when the price goes down ‘for no reason’ or hold when the price goes up even if I may have lost faith).

I once did a team building exercise where about 30 of us had to imagine we survived an emergency plane landing in a desert. We had to rank about 20 items by usefulness, first individually and then as a whole group. To my astonishment the team score beat mine (over confidence!!). Not only that, it beat everyone else’s individual effort! That lesson stuck with me and I think there is a read across to EMH whereby over confidence is an ever present danger for me and it really is quite difficult to beat the consensus.

Funds vs DIY

I find the dynamic of PI vs Institution completely fascinating. Both sides have huge advantages and disadvantages over the other!

‘They’ (the institutions) have inside information that ‘we’ (PIs) don’t have. And they have massive resources to weight and crunch that information quickly, which we also don’t have. We, on the other hand, do not have the bosses, policies, clients, and £m bonuses that all cloud the institutional decision making process. We are also more agile being able to ‘go all in’ on our best ideas, as well as trade in and out of positions (or the entire market) quickly.

And ofcourse if we PI’s throw the towel in and hand our money over to the funds then we still have to do quite a lot of work choosing which funds to invest in. And all of them charge high fees which will take a chunk out of theoretical returns.

My Approach

I have been investing for 27 years and returned 12% CAGR (including all costs, dividends, mistakes, years of neglect). That compares to 3% for the FT100 and the 5% for the FT Small Cap (both excluding dividends and fees).

I spend 14 hours a week on my investing but I could probably chop a few hours off that now I know what I’m doing.

I have tried lots of strategies but the only one I ever made money out of was growth. I now look specifically for profitable growth but with a very long ‘runway’, i.e. I only invest in shares that I think have the potential to be held forever – that basically means companies in good markets or with good management or ideally both.

By outlining my approach I am certainly not saying mine is the best or only way to make money. On the contrary, one of the things I like about investing is there are lots of ways to make money – it’s just that growth is the only one that has worked for me personally.

I don’t diversify my approach; all my wealth is managed by me (apart from a couple of small corporate pensions which I wish I had transferred but didn’t). I started in my 30s so I had plenty of time to evolve a market beating method. I think if I started investing in my 50s then maybe I would have been forced to take a more diversified approach.

I don’t have much to say about market anomalies; I think they do exist but the trends are so weak that I doubt I could make much money exploiting them with out excessive leverage (I have none) or risk.

Finally if you’ve got this far, if anyone is interested in deeper discussion on EMH (i.e. a well thought through rant about why it’s very possible to beat the market) then I recommend the writings of David Dreman.

cmpeckham

18th Jan '22

My perspective:

1. The market is mostly efficient, most of the time. Conversely, you will almost always find pockets of irrationality of you look hard enough and sometimes the whole market is irrational.

2. There has to be an element of inefficiency to keep active investors in the game. If there is no profit in active investment, money will flow in to passive investment and prices will become inefficient again.

3. There is "wisdom in crowds" but only when each member of the crowd acts largely independently. HHR in their comment above recounts an experience of a team building exercise where the team score was better than each individual score. This is another version of the classic tale from Francis Galton in which the average guess of the weight of an ox by the crowd at a county fair is much better than the vast majority of individual guesses. Markets are often close to this state, but sometimes the individuals become too heavily influenced by what other participants are saying (SELL, SELL, SELL!!!) and the independence of individual estimates breaks down, resulting in inefficient pricing.

4. The EMH doesn't say you can't beat the market. It says that you can't do it consistently without taking on more risk. Many anomalies are in fact all about taking on more risk. For example, the best returns historically have gone to those who were invested from Nov to Apr. This is because human beings have evolved to be risk averse heading in to winter. It is no coincidence that halloween occurs when we are most easily spooked. The historical rewards have gone to those who bought when others were feeling risk averse. Those who bought in May when the crowd was relaxed and full of the joys of spring got the worst returns.

5. Anomalies will come and go. There are many examples of an anomaly being well publicised and then being eliminated. The anomaly falls victim to its own popularity. I think that for an anomaly to persist, it has to genuinely represent additional risk, or it has to be impossible to eliminate via popularity. To me, value investing is about taking on more risk, so it will persist over time. Momentum investing is impossible to eliminate via popularity, so will persist over time. For quality investing on the other hand, it satisfies neither criteria so I suspect that, after a decade of success, it will now start to fall back out of favour.

That's my personal view anyway...

The ‘Efficient Market Hypothesis’ and ‘Market Anomalies’

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Gilgamesh_Investor

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