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, things will become more apparent by the end of the post.
What is the Efficient Market Hypothesis (EMH)
EMH states that market prices contain all available information. It should, therefore, be impossible to beat the market consistently on a risk-adjusted basis, as market prices should only adjust to new information.
Nobel prize-winning academic Eugene Fama was awarded a Nobel Prize in 2013 for his groundbreaking research on efficient markets, proposing three levels of market efficiency.
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.
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.
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 (also featuring economist Richard Thaler), Fama points out that the EMH is just a model and not wholly accurate. However, he then says he doesn't know of any investor who shouldn't behave as if markets aren't efficient.
It's this second point that led me to write this blog! We believe it's a more nuanced discussion, with market efficiency very much dependent on the investor and their investing horizon.
Chuckling at the EMH
Many years back, I firmly believed in EMH, believing no one could consistently outsmart the market. However, one fateful day, my beliefs were shaken. I talked with someone who chuckled at me when I suggested that I believed markets were efficient. Frustratingly, they had the track record to prove it, which sowed the seeds of doubt in my mind.
Richard Thaler once said:
“Markets look a lot less efficient from the banks of the Hudson than from the banks of the Chicago River.”
I set out to build my understanding of how the EMH applies in the real world, away from academia.
A Physics diversion
In the introduction, we said that we would look at the links between the markets and physics, and below, we cover four physics concepts, and we will subsequently describe how they can be used to understand markets and market efficiency.
Time Dilation
Time dilation is 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 moving more slowly than one sitting next to them.
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). However, as an object increases in speed, its mass also increases, which means we must make allowances.
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.
Radioactive decay
Radioactive decay is when an unstable atom loses energy over time through radiation.
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 the competition in markets continually rising, making it harder to beat them. Before writing this blog, I wanted to complete two other posts highlighting this point.
Ed Thorp
Ed Thorp is a legendary card counter and investor who has been able to beat 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, these methods eventually became commonplace, removing the edge and, therefore, the ability to beat the market. Thorp eventually closed his (second) fund in 2002 as competition increased.
Renaissance Technologies (Rentec)
Rentec's Medallion fund is considered to have the greatest track record of all, returning over 66% annualised before fees over30 years from 1988 to 2018. As you can see from the blog, the resources needed to accomplish this are formidable and probably one of the reasons why Thorp (who, let's not forget, is one of the world's greatest investors and brightest minds) found it harder and harder to compete. The current CEO of Rentec pointed out that their system has taken decades and billions to build!
The Physics Link
I mentioned returning to the four Physics examples and how this relates to the markets and their efficiency.
The efficiency of markets is very much dependent on your observation point (Time dilation). If you are observing the markets from within a firm such as Rentec, the market in no way looks efficient, and they have been able to exploit these inefficiencies over time. The remaining >99.9% of investors' observations of the market will be very different.
Newton's Second Law applies in most circumstances, and the same is true of market efficiency for most investors, with most lacking the brain or computing power to clear the (high jump) bar.
The amount of money that can be extracted from the market at any point is finite, with trading tending to move the market, which Rentec founder Jim Simons describes in the above interview. This is analogous to the observer effect; by extracting profits, you are removing inefficiencies for the remainder of market participants. This may also include Rentec's other funds, which have longer holding periods.
Half-life describes how quickly atoms decay, and the same tends to be true for a given market-beating strategy. Eventually, other market participants figure out what you are doing, and the edge eventually disappears.
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 undertook an analysis of 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
The SPIVA benchmarks are produced by S&P and demonstrate 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 discussion 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
Market efficiency is very much a function of your observation point and not a generalised theory.
The hurdle for beating the market gets higher over time, with more failing to clear the high jump bar.
Markets can be beaten by a select few over shorter horizons (a holding period of a few days). For those with longer-term holding periods, this becomes even more difficult.
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**
Next steps
If you would like to us 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 advice, investment advice 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!