Market efficiency

by Chris Kerlow, CFA

“Is that a $20 dollar bill lying on the ground?” asks the student
“No it can’t be”, answers the professor. “If it were, someone would have picked it up by now.”

– Caption from Howard Marks’ The Most Important Thing

The efficient market hypothesis (EMH) was developed in Chicago during the 1960s and 1970s with the premise that it is impossible to beat the market as share prices incorporate all relevant information. In such an environment, the more risk one assumes, the greater the return. This is depicted in the first chart, as risk rises, so does expected return.  Yet in reality things are never so clean.  Chart 2 depicts an environment with many possible outcomes given various levels of risk. With so many scenarios, can the market really be efficient.  Today there is a large body of research that supports EMH and an increasing amount that refutes this claim. In this edition of Market Ethos, we will share some of the evidence and factors that appear to determine just how efficient different markets are.

Market Structure – The reality is there are frictions to investing that limits market efficiency. In an academic world, which does not exist in the real world, investors would act independently, willing to go long or short with little transactional friction. This is clearly not the case even in the more efficient large cap equity markets as there are many more long only investors compared to those willing to short a stock or the market. This structural bias limits EMH.  There is also transaction costs and informational availability. For large cap equities, information is widely disseminated and transaction costs are low.  Yet in some markets, this is not the case.  Real estate for instance has much higher transaction costs and information is not as easy to obtain. This limits EMH.

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Charts are sourced to Bloomberg unless otherwise noted.

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