Saturday, April 10, 2010

Efficient Market

‘The Myth of the Rational Market’ is a great book that explains recent economic theories in an easy to understand manner. A good supplement to Benoit Mandelbrot’s book ‘The Mis-Behavior of Markets’. Justin Fox’s book wisely avoids the equations and technical jargon that would have made the book unsatisfying. Finally I understood what it meant to believe or not to believe the theory of an efficient market. I had a fuzzy idea and did not realize the nuances and subtlety of this theory or its influence in my investment decisions. I did not believe it although I thought I did – such confusion! If one agrees with the theory then one does not accept the ability of great investors like Warren Buffet and George Soros.

But the theory is now discarded with the reality of recent events. I always thought that the common wisdom was to invest in index funds which indirectly subscribes to this theory. The theory basically states that prices in the stock market are random and reflects the latest information. It does not account for the behavior of the herd or stock speculators who blindly sell due to rumors or noise generated by shows like MSNBC. Generally one cannot beat the market by timing it. One should invest in the long term as stocks generally rise in the long run. One would have a difficult time choosing individual stocks unless one follows the advice of the Benjamin Graham – Warren Buffet school of thought.

Hence, buying stock even if one chooses so-called value stock is a big risk. Prices do not follow historical trends. Benoit Mandelbrot does not agree as his fractal theory seems to say that future price movements reflect ‘traces’ of past performance. I guess fractal theory and the efficient market theory aim to provide a general theoretical structure to explain the stock market. On the other hand, people like Warren Buffet and George Soros believe that the market is inefficient which allows them to buy undervalued stocks and profit in the long term. Their belief can be said to follow the other school of thought – the behavioral economists that say that people are subject to cognitive biases. These cognitive biases result in an inefficient market.

A belief in the inefficient market means that investing in the stock market entails great financial risk as compared to a belief in an efficient market. So one should develop a ‘rational’ mind to get rid of any cognitive bias or overconfidence that one may have when investing in the market. George Soros tries to provide a philosophical framework (based on Karl Popper’s ideas) that would allow one to invest by essentially proving a bet wrong. It’s his view that the market exhibits ‘reflexive’ phenomenon (i.e. reacting to participant’s views), similar to John Maynard Keynes thought that the market is like a gigantic beauty pageant where people vote on the best looking stock.

So how does one become a successful investor? One cannot even attempt to understand the mind of the market but one cannot beat success. Value investing seems to provide the best answer. Choosing under valued stock with criteria’s like P/E ratios below 20, choosing business with good long term strategies and good products, an excellent management team, having a global business model with large capitalization is one approach. So I guess I can now say with confidence that I believe the market is not efficient, it’s driven by cognitive bias and herd mentality. Stock prices are not random and do not reflect all available information. I guess this belief does not rely on mathematical economic theories but on a basic understanding of human nature.

Nevertheless, people like Warren Buffet do advise inexperienced investors to buy index funds as the best way to invest in the stock market. This does not mean he believes in the efficient market theory but on the realistic understanding that the stock market does rise over time (or over the long run) and the market is the most innovative engine that fuels the American economy. This means that investing in the stock market is not a great risk but a great investment if done conservatively. But one needs to make allowances for aberrations like the recent crisis and avoid cognitive bias which results in selling when prices are low (or buying when prices are high). Buying and holding index funds like ETFs seems to be the most conservative option for most people.

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