Joel Stern Profile of Stern Value Management

What if Capital Markets are "Efficient?"


By Joel Stern (adapted by SVM)

Many have questioned my references to "sophisticated" investors and the implication that the stock market is efficient because such investors dominate it.

How, they ask, can you reconcile that view with the wild swing in prices we have seen in markets from Asia to Wall Street? How do you account for the fact that fads often account for price movements? Some of the critics appear to think that the market is dominated by unsophisticated investors who allegedly are looking for capital gains from price movements unrelated to anticipated future corporate profits.

To examine market behavior one must define an "efficient" market and see what implications this holds for investment analysts and money managers.

A capital market allocates the ownership of an economy's capital. Ideally a market should provide a way for companies to raise money for profitable investment and for investors to purchase securities at prices which "fully reflect" all relevant information about companies' activities and prospects. In an efficient market security prices always "fully reflect" available information.

In efficient capital markets, prices are "unbiased estimates" of "fair" market values. If the current price is not a "fair" one, it is just as likely to be above the fair price as below it. If investors believe that the market price and the fair price are different and, for this reason, buy shares they will not in the long run make money. Occasionally of course they will make a profit, but over a period they will be incorrect often enough to cancel their gains.

In an efficient market sophisticated investors ensure that fair prices and market prices are almost always the same. Sophisticated investors make strenuous efforts to lay their hands on price-sensitive information so that they can identify overvalued and undervalued securities before anyone else.

However, sophisticated investors rarely outperform the market which shows that individually, they have no monopoly of price-sensitive information. If they did have a monopoly, other investors would no longer attempt to seek new information and the market, starved of well-briefed operators, would become inefficient.

An important concomitant is that in efficient markets, unsophisticated investors are protected by the activities of their sophisticated brethren. In other words, even if some investors do not understand the securities markets, their sales and purchases on average and over time will be at fair prices.

Thus, the market performance of sophisticated and unsophisticated investors should be about the same. The unsophisticated could, however, do worse if they make an excessive number of buy-sell transactions and incur heavy costs (even though transaction costs have reduced significantly over the years).

In efficient markets, investors can achieve a performance equal to the market as a whole simply by selecting securities at random. This means that security analysis is a waste of time once efficiency has been established unless analysts' recommendations consistently outperform market indices. Even if a particular analyst does outfox the other foxes, his performance may only be equal to the market as a whole if his recommendations are adjusted for risk.

For example, assume the stock market rises 10 per cent in value through cash dividends and price appreciation. If an analyst's recommendations are twice as risky as the general market, he must earn 20 per cent in nominal terms to equal the market's performance in real terms. Only if he earns above 20 per cent has he outperformed the market. If superior performance cannot be achieved, the only sensible portfolio strategy is a randomly selected buy-and-hold policy.

If investors wish to take more or less risk than the market, risk should be calculated for various alternative portfolios. Then the investor's risk preferences should be matched with randomly selected portfolios of identical risk. Identifying investor's risk preferences and selecting suitable portfolios is the investment advisor's role in efficient markets. These days it is perfectly possible to measure investment risk.

Although risk-adjusted rates of return are the correct way of measuring performance, they are not widely used among the financial community. When the performance of security analysts and money managers is measured on a risk-adjusted basis, the evidence shows that the "experts" do not outperform the market.

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