Tuesday, November 26, 2019

Market Efficiency and Hard Thinking -

Warren Buffett once thanked the disciples of the efficient market hypothesis, referring to them as “opponents who have been taught that thinking is a waste of energy”.  - Shareholder letter 1985

Thinking is hard; that is why we do so little of it. Thinking requires looking for links between the past and predictions of the future. Sometimes these links are present. Sometimes the links change in unexpected ways. Information gathering, which is the first step in finding a link, is hard especially if you are looking for something new in the data or for new information. Most times the links between information are poor and filled with noise, yet there has to be some investors who work at making markets efficient. Most will not be successful, but the process is critical. 

The paradox of market efficiency - 

  • If everyone thinks the markets are efficient or there are no rewards from research, then no one will gather and use information and the markets will become inefficient.
Some corollaries -
  • If everyone uses the same bit of information and model, the speed of adjustment or reaction to any new information release will increase and the value to the marginal investor is zero. 
    • Market efficiency is about both being right and understanding behavior quickly.
  • Passive investing cannot make markets efficient. 
    • Passive investors are information agnostic.
    • If you do not have an information edge, it is better to be information agnostic
    • Most perceived information edges do not exist.
    • Passive investors are asking others to make markets efficient.
  • Active investing does not ensure market efficiency. 
    • Active investing will not always be rewarded with greater returns.
  • The mix of economic agents trading in a market affects market efficiency.
  • Smart investors are not guaranteed success.
    • Being smart does not mean an investors can decipher market behavior or profit from it. 
  • Less smart investors will not always be eliminated from the market.
    • Smart money does not drive out not so smart money. 
  • There are limits to arbitrage 
    • Making markets efficient from arbitrage opportunities requires capital and this capital may be finite.
  • Central banks (non-profit maximizers) will not make markets efficient and lead to inefficiencies.
    • Hedgers may not be profit maximizers.
    • The size of players who are not profit maximizers varies by markets so efficiency differs across markets. 
  • Beliefs can be rational but can be wrong and lead to inefficiencies.
    • The can be many rational beliefs but only one market reality.
  • Just when investors figure the market out, there will be a new problem.
    • There is no market end game.
  • If there are fewer analysts following a market, there will be greater opportunities.
    • More analysts and capital following a market makes the speed of adjustment faster.
  • Behavioral biases can be contained but not eliminated
    • Bad behavior leads to inefficiencies and more uncertainty will increase bad behavior. 
  • Efficiency is a dynamic concept. The efficient market of today may be inefficient tomorrow.
  • Risk premia will still exist in efficient markets 
  • Markets are often micro efficient but macro inefficient.
    • If fair value cannot be determined it is harder for a market to be efficient.
    • If there is no idea of what is fair value, new information will be misused.
  • Our idea of market efficiency has evolved over the last few decades. 

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