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  • Writer's pictureNoel Watson

Are stock markets efficient? No, but they are for you!

Updated: Sep 8

A tale of physics, high jump and investing


Introduction


I used to love the high jump at school. After each round, the bar was raised, and more and more competitors dropped out, leaving just the victor (occasionally me!). I used the scissor jump, but the event has moved on, with my children now using the Fosbury flop - a technique pioneered by Dick Fosbury.


I also loved Physics (and still do)*, and for some time, I've pondered the similarities between the topics I studied and how the markets function.


This article examines the links between the high jump, physics, and the stock markets. Hopefully, the connections will become more apparent by the end of the post!




What is the Efficient Market Hypothesis (EMH)?


The EMH states that market prices contain all available information. Therefore, it should be impossible to consistently beat the market on a risk-adjusted basis, as market prices should only adjust to new information.


Academic Eugene Fama was awarded a Nobel Prize in 2013 for his groundbreaking research on efficient markets, proposing three levels of market efficiency.


  1. Weak form efficiency: Current security prices reflect all information from past prices. Future price movements, therefore, cannot be predicted using past prices, effectively proposing that technical analysis doesn't work.

  2. Semi-strong efficiency: Asset prices reflect all publicly available information. Therefore, neither fundamental nor technical analysis can give an investor an edge, and only those with inside information have an advantage.

  3. Strong-form efficiency: Asset prices reflect the public and inside information available. Therefore, no one can have an advantage in predicting prices.



Does EMH apply to all investors?


In this interview (which also features economist Richard Thaler), Fama points out that the EMH is just a model and is not wholly accurate (something he reiterated in a recent FT article). However, he then says he doesn't know of any investor who shouldn't behave as if markets aren't efficient.


This second point led me to write this blog! We believe market efficiency is a nuanced discussion that is very much dependent on the investor and their investment horizon.



Chuckling at the EMH


Many years ago, I firmly believed in the EMH, believing no one could consistently outsmart the market. However, one fateful day, my beliefs were shaken when I talked with someone who had experienced great success in the financial markets. They chuckled at me when I suggested that I believed markets were efficient, and frustratingly, they had the track record to prove it, which sowed the seeds of doubt in my mind.


Fischer Black, one of the authors of the Black-Scholes equation, once said:


“Markets look a lot less efficient from the banks of the Hudson than from the banks of the Chicago River.”


effectively implying that real-world markets were less efficient than academic theory suggested.



A Physics diversion


In the introduction, we said we would look at the links between markets and physics. Below, we cover four physics concepts and describe how they can be used to understand markets and market efficiency.



Time Dilation


Time dilation can be demonstrated by the difference in elapsed time between two clocks, either because they have travelled at different speeds or heights relative to Earth.


In the Hafele-Keating experiment, two clocks were placed on aeroplanes that flew around the world, while two remained on the ground. When the clocks were reunited, they were found to have slight time differences, consistent with the theory that an observer will see a moving clock run more slowly than a clock sitting next to them.


Renaissance Technologies' (Rentec) Medallion fund is considered to have the greatest investing track record of all, returning over 66% annualised before fees over 30 years from 1988 to 2018. As you can see from the blog link, the resources needed to accomplish this are formidable. The current CEO of Rentec pointed out that their system has taken decades and billions to build!


Similar to time dilation, we believe market efficiency is related to your observation point. The market does not look efficient if you are observing from within a firm such as Rentec. The remaining >99.9% of investors' observations of the market will be very different.



Newton's Second Law


Newton's Second Law states that the force applied to a body equals its mass multiplied by its acceleration. We tend to know this law by its formula (F=ma), and this equation holds true for most calculations. However, as an object increases in speed, its mass also increases, which means the formula no longer works in its standard form as the object approaches the speed of light.


To emphasise our point above, we believe that most market participants should behave as though the markets are efficient and that the EMH "law" applies, as they lack the brains or computing power to invalidate it.



Observer effect


In physics, the observer effect describes the impact of your observation on an object. A (relatable) real-world example is when you check your car tyre pressures, during which some air will typically escape.


Market participants are impacted in a similar way; every order they place in the market has an impact. As Rentec's Jim Simons (RIP) explains, this limits the amount of profits that can be extracted from the market. This is analogous to the observer effect - by extracting profits, you remove inefficiencies for other market participants. This may also include Rentec's other funds, which have longer holding periods.




Radioactive decay


Radioactive decay occurs when an unstable atom loses energy over time through radiation, and this is measured by half-life. In the markets, what was once an edge (a profitable trading strategy) eventually decays as other market partners figure out how to exploit this inefficiency.


Ed Thorp is a legendary card counter and investor with a track record of beating the market for many years. He described how using his models was like "firearms vs bows and arrows" on the trading floor, with other market participants using far more primitive methods. However, his advanced methods eventually became commonplace, meaning that the edge decayed and the ability to beat the market got more difficult. Thorp eventually closed his (second) fund in 2002 as competition increased.



The evolution of market efficiency and high jump


I mentioned earlier that I had observed an evolution in the school high jump, from the scissor kick to the Fosbury flop. The men's world record for the high jump has increased from 1.97m in 1895 to 2.45m today. We believe the efficiency of the markets has followed a similar trend, with competition continually rising, making it harder to beat them.


Our understanding of physics and how the Universe works continues to evolve. The same is true of investing. Take Warren Buffett as an example. Like us, he's not a believer of the EMH and is often cited as an example of someone who has violated the theory. In 2013, AQR analysed Buffett's returns and found that these were due to the investing styles (and leverage) that Buffett adopted and not due to him beating the market. These styles were unknown years back, but as our understanding of what drives investing returns evolves, strategies/legendary investors that were once considered to violate the EMH turn out not to.



SPIVA benchmarks - why they don't prove market efficiency


S&P Global Ratings produces the SPIVA benchmarks, demonstrating the percentage of retail active managers that underperform a benchmark (sadly, far too many). This is often held out as an example of how efficient markets are. Based on the discussions above, we'd suggest it's more related to the retail active managers' observation point. They lack the resources/abilities to clear the high jump hurdle, and therefore, the market appears efficient to them (they trail the benchmark partly due to costs). We often read of people using a core-satellite approach, investing passively in "more efficient" markets and actively in those that believed less so. Alas, the SPIVA data proves this not to be the case, and the fund manager is most likely going to have the same observation point in whichever market they are trading in.



Conclusion


  1. Market efficiency is a function of your observation point, not a generalised theory.

  2. The hurdle for beating the market increases over time (as shown by the sketch below), with more failing to clear the high jump bar (although some argue that the market is becoming less efficient over time).

  3. A select few can beat markets over shorter horizons (a holding period of a few days). For those with longer-term holding periods, this becomes even more difficult.

  4. Based on the above three points, it's probably best to assume that the market is efficient for you and any asset manager you have access to**

Beating the market - it gets harder over time!
Beating the market - it gets harder over time!

Next steps


If you want to know more about investing and overall retirement planning, please get in touch.


About us


The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide pension, investment and inheritance tax advice.


Our office telephone number is 01932 645150.


Our office address is No 5, The Heights, Weybridge KT13 0NY.


Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.


Although best efforts are made to ensure all information is accurate, you should not rely on this blog for your personal situation or planning.


The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.



*For Physics buffs reading this, apologies if my concepts are rusty. I'd love to go back and study the subject again. For non-Physics buffs, apologies too - hopefully, some of the concepts make sense!

**Unless you have a setup similar to the person who chuckled at me! But they are few and far between!




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