Inefficient Markets — Are The Markets Really Efficient?
- Jonathan Quek
- May 1
- 5 min read
What is the efficient market theory? How true is it? And does it stand up to scrutiny?
In the 1970s, efficient market theory, popularized by Eugene Fama, was the new and hot Monroe of academic finance. It seemed like the perfect little theory to explain our highly complex financial landscape. A theory that, at its peak, had an almost religious zeal behind it, a craze, a loyal fanbase consisting of academic behemoths. Yet perceptions have shifted drastically. Today, the theory is constantly criticized for being overly simplistic and for not being widely applicable. It has been denounced by well-respected financiers like Jim Simon, Warren Buffett, Charlie Munger, and Noam Chomsky. They point to their consistent above-market returns as justification that the theory is flawed. Today, we will examine the theory with a more theoretical lens, taking a deeper dive into its nuances and examining some of its flaws.
History
An efficient market is one where security prices fully reflect all available information. Hence, as the theory claims, it is impossible to beat the market on a long-term risk-adjusted basis. The origins of the efficient market theory can be traced back to French mathematician Louis Bachelier, who in the 1900s, published a groundbreaking work about ‘The Theory of Speculation’. He introduces the idea of ‘random walks’, that asset prices move in a fundamentally unpredictable way independent of prior movements. The theory really took off in the 1970s thanks to Eugene Fama and his work ‘Efficient Market Capital’, as well as the advancement of computers which made calculating and comparing asset prices easier.
The definition of the model brings about some controversy. According to the model, it is impossible for investors to make above market returns on a long term risk adjusted basis, yet there has been much debate and controversy surrounded how ‘risk’ is defined and calculated.
Assumptions of the Model
Efficient markets are based on 2 broad assumptions. Firstly, it assumes that all investors are rational, and those who are irrational trade randomly, cancelling each other out. To the extent that those who are irrational trade in similar ways, they are met with market arbitrageurs who eliminate their influence on price.
Arbitrageurs are investors who short stocks that are overvalued and buy close substitute stocks which are undervalued, thus shifting the prices of the asset to its fundamental level. Essentially they make money from riskless trades that exploit the price discrepancies in markets.
Secondly, new information is reflected in the prices of security quickly and correctly. Information that is not ‘new’ is considered ‘stale’. How stale information is defined leads to different variations of the model.
In the ‘weak’ form of efficient markets, stale information refers to all past information regarding price and returns. It posits that investors can’t make above-market returns on a long-term risk-adjusted basis using past information.
In the ‘semi-strong’ form of efficient markets, stale information refers to all publicly available information. This is to say that all publicly available information has already been factored into the price of the assets. In this form of the efficient market hypothesis, it is still possible to beat the market through insider trading.
In the ‘strong’ form of efficient markets, stale information encapsulates an even broader category, encompassing all information public and private. This implies that even insider trading does not yield greater than market returns.
Most consensus agree that strong-form efficient market is rarely applicable, and hence we will focus largely on weak and semi-form strong forms.
Issues with Efficient Markets
Phew… that was a lot of technical jargon, but bear with me here. Let’s now examine some of the issues with this theory of markets.
The first issue arises from the assumption of rationality. Although the model is able to account for irrationality, the explanations provided are still inadequate in many circumstances. Firstly, irrational investors do not produce random trade since their irrationality is not random. Investors are human and are subjected to the same psychological tendencies. You would know this if you have ever gone shopping. You see a dazzling piece of clothing, its smooth linen calling for your warm body. It’s got to be $50 at least, so you check the price tag. $200! Dang… that’s even more than you thought. But a salesman comes by and tells you it’s 50% off. $100 huh, not a bad deal for such a great piece of clothing! You’ve just fallen prey to anchoring bias.
Investors face all sorts of similar cognitive bias that causes security prices to swing wildly instead of fluctuate randomly. To account for this, the model postulates that arbitrageurs take the other side of the demand and bring the asset down to its fundamental value.
Yet even this seemingly brilliant fix presents a few loopholes itself. Firstly, the market may remain inefficient longer than investors can remain solvent. This means that even if an investor was right to place his bets based on the fundamental value of the asset that is currently mispriced, the markets could move against him till he is forced to cut his losses. The possibility of making losses also brings risk into the equation which introduces the problem of how do we calculate and account for risk? Aside from this, shorting stocks are also regulated and in some places, outright banned. Without being able to short a stock, arbitrageurs cannot exploit the price discrepancies in similar markets.
There are also issues with the idea that information is reflected into the prices of assets and hence the its prices should be traded at their fundamental value. A core principle of efficient market theory.
Closed-end funds are funds that issue a fixed number of shares at the beginning, which can then be traded on the market just like other assets. Unlike other funds, investors can only buy and sell shares on the market according to the prices of the shares instead of redeeming those shares at their net asset value (NAV). This is where it gets interesting. If we go according to the efficient market hypothesis, the shares of the fund should trade at the fund’s NAV, which is also its fundamental value. Yet many close-end funds trade at a discount of around 10–15%. This is to say that the shares trade at a value less than the intrinsic worth of the assets the funds hold. How? Does that not violate the very principle of efficient market theory? Yes. Yes, it does.
To be very fair, there has been some justifications provided by proponents of the theory which I won’t delve into since laying out all arguments and counterarguments would make this article longer than all the dune franchise combined. It suffices to say that despite the counterarguments, the close end fund puzzle remains one of efficient market theory’s most glaring issue.
Epilogue
Despite all of this, I think it is important to give the model its due credit. Firstly, the weak and semi-strong forms are both widely applicable and a good simplified model for most retail investors. For those seeking passive investments and a more hands-off way to operate their investment portfolio, assuming market efficiency is sufficient in most scenarios. And for how simple the model is, it has stunning accuracy in predicting many normal circumstances. Most importantly, it is an important piece of economic and financial history, and we are all better served understanding this model whether we agree with it.
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If you are interested in more finance-related articles, check out some of my other works on finance!
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