Part one of our series introduced the efficient market hypothesis. Part two explored evidence in the mutual fund and pension plan worlds that showed that while the EMH fails all the tests of efficiency, it passes the only test that really matters - are active investors likely to outperform appropriate benchmarks after the expenses of the effort? Today, we'll look at how the markets become efficient.
Markets are made efficient by the participation of many active investors, each of them attempting to gain a sustainable competitive advantage in terms of information. It's important to understand that the competition among all the highly skilled competitors makes it very difficult to gain any competitive advantage. The ability to rapidly incorporate new information is so great that the market quickly eliminates most excess profit opportunities.
Does the existence of an efficient market make it impossible to gain a competitive advantage and be able to outperform the markets? That's not a likely proposition. However, it does mean that the competitive advantage is likely to be short lived. In other words, "an occasional free lunch is permitted, but free lunch plans are ruled out." Let's explain.
The revolution in computer technology has made possible the testing of various strategies based on computation intensive research that wouldn't have been possible until fairly recently. Given the computational and intellectual power being applied to the task (and given the size of the potential rewards), it isn't logical to believe that strategies could never be uncovered that could exploit market inefficiencies. Intensive research analysis may reveal anomalies between security prices that could be exploited. A good example of that is the recent work on profitability/quality as a factor explaining returns.
It's important for investors to understand that while the rewards for uncovering anomalies are great, it's also true that the most anomalies aren't likely to last very long (unless limits to arbitrage and high costs prevent the anomaly from being eliminated). First, the barriers to entry are very low in the financial arena. Second, large profits will quickly attract competition that will "reverse engineer" the process to understand how the profits were derived. Thus, it's likely that competition will quickly restore the market's efficiency and eliminate the anomaly. A great example is the recent demise of Long Term Capital Management. The firm was built upon research that discovered anomalies between certain securities' prices. These anomalies could be exploited to gain profits in excess of what appeared to be the risks involved. The company generated tremendous profits in its first few years. Those profits attracted lots of competition, and the profit opportunities began to shrink. In order for the firm to continue to generate the same types of returns, they now had to use large amounts of leverage. Now risk and reward were once again related - the anomaly having disappeared, or at least shrank dramatically. The firm ultimately lost billions of dollars as the risk side of the equation overtook the reward side.
The reward for uncovering an anomaly is the economic profits that can be reaped. And, in the capital markets arena, opportunities for great rewards attract great amounts of competition. Economics professors Dwight Lee and James Verbrugge explain the power of the efficient markets theory in the "The Efficient Market Theory Thrives on Criticism":
The efficient markets theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear efficient market anomaly is discovered, the behavior (or lack of behavior) that gives rise to it will tend to be eliminated by competition among investors for higher returns…(For example) If stock prices are found to follow predictable seasonable patterns…this knowledge will elicit responses that have the effect of eliminating the very patterns that they were designed exploit…The implication is striking. The more the empirical flaws that are discovered in the efficient markets theory the more robust the theory becomes. (In effect) Those who do the most to ensure that the efficient market theory remains fundamental to our understanding of financial economics are not its intellectual defenders, but those mounting the most serious empirical assault against it.
Tomorrow concludes our series with a summary of what's been discussed so far about the EMH.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.