The Irrelevance of Efficient Market Hypothesis (EMH)
As I was writing this (30th May), the Markets went up more than 1000 points (specifically ONE particular indicator of the financial markets went up 1000+ points). Tomorrow, therefore there will be headlines in newspapers about how “Investors” became richer by several lakh crore rupees. A few days ago, it went down by more than 1000 points. Therefore, the same newspapers declared that “Investors” became poorer by several lakh crore rupees.
I am an investor – in the sense that whatever I earned and did not spend during my productive years, I kept aside to pay for my future self! Did I really become richer yesterday, making me happy that tomorrow I can afford to eat cake instead of bread? And Did I really become poorer a few days ago causing me to worry about having to eat bread instead of cake?
These questions arose in an argument amongst a group of friends – the primary point that the argument revolved around however was, can you beat the market and do better by making use of these peaks and troughs and keep doing so consistently over the long term?
But unlike usual arguments which have two sides, this one had three – one side claimed, “Yes you can”, the second position was “No you cannot” and the third (a minority to which I belonged to) was asking “Why should you even bother to?“
Interestingly, the Yeas and the Nays both were basing their arguments on the same principle – something called the Efficient Market Hypothesis (EMH).
The Nay-sayers argument was – According to EMH, the market prices already take into account ALL information available that has any bearing on the prices of the assets under consideration and therefore no one can beat the market consistently for a long time. This is because whatever information they base their decisions on will already have been taken into account by the market and therefore they cannot buy at a price lower than the market and cannot sell at a price higher than the market.
The Yeas argued that while that may be true in the US or the developed markets in general – OUR markets are NOT efficient. There is a great deal of information imbalance. And even if the imbalance in principle was not a problem, in reality the way our markets function, they react so slowly to new information as it becomes available. And therefore, there are considerable periods in which the market prices do not reflect ALL available information. Therefore, by making use of such information which is yet to be incorporated in the prices, you can beat the market.
The “third” party’s argument was, first of all there is a very distinct possibility that the Efficient Market Hypothesis actually may not hold at all – at least not all the time, notwithstanding the fact that the economist Fama got a Nobel prize for formulating it. Markets and prices are influenced as much by rational information as by greed, fear, distress, acquisitiveness, endowment effects and so on. And none of them find a place in the formulation of EMH.
How do you factor greed in an excel sheet? How can you factor fear in the same excel sheet?
Of course, one could argue (anyone can argue anything even if it is just a baseless opinion) that the effects of ALL these irrational factors too can be modelled as pieces of information which the Markets take into account and therefore EMH holds.
But the real question is – Why should you bother with EMH at all? The real question that one should be asking is – whether the daily swings really make you a pauper one day and a king, the next? Is your financial health so precarious that a drop of a thousand points on a given day, makes you go hungry and without a roof on your head, the next day and a rise of a thousand points enables you buy a Porsche?
This same question can be thought somewhat differently by doing an exercise.
For as far back as the data about the daily market value movements exists, let’s do the following calculation.
Pick a period of 5 years (or 10 or 6 but not 1 or 2) in the past (for which market data exists) at random. Assume that you invested Rs 100 on the first day of that period and calculate how much money you would have on the last day of that period. Do this exercise a thousand times (i.e. picking a 5 year period randomly and doing the calculations). What percentage of these 1000 calculations will result into you having less than 100 rupees on the last day of that period? That is the probability that you will be poorer than you are in the long run.
I am willing to bet the answer will be that the probability is very very very small if not actually zero!
And while as they say, past is not a predictor of the future, as long as we are not talking about a total collapse of the economic systems of the world as a whole or the bankruptcy of an entire nation like Venezuela, that is the answer you will always find. And if you ARE talking about such collapses or bankruptcies, then EMH or any other economic theory won’t save you anyway!
Of course, within many of those 5-year randomly chosen periods you will find some days, on which you had much less than what you had on the first day and some other days on which you had much more than whatever you had on the last day of that period! But do those intermediate days on which you were apparently poorer or richer than what you really are, matter?
So, as long as you have been prudent in saving and investing for your future self (you know how much is enough so that you never ever have to worry about money), why bother with EMH – no matter how intellectually stimulating discussions about its consequences may be!