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What is the “Efficient market hypothesis” and its implications
Markets are efficient to some extent so it’s extremely difficult to beat benchmarks
The so-called Efficient Market Hypothesis propounded by Chicago University professor and Nobel laureate Eugene Fama postulates that any stock-specific fresh information gets priced into the stock immediately. As per this theory, every information about a stock as on a particular date gets reflected in the stock’s current price. This information can be any piece of data or news that drives the stock’s fair value; for example, the quarterly result of a company.
This hypothesis states that mispricing in the market is a fleeting event. Stock price movements are caused by emergence of new information.
An important corollary of the Efficient Market Hypothesis is that it is impossible for any investor to beat the market benchmark consistently over a long period. Since every information is absorbed quickly by this efficient stock price discovery machine, there is no way even smart, hardworking investors can have any edge.
Now, not many would deny the remarkable prescience that markets display at times. Take the example of the way Indian markets behaved in early 2020. After nosediving by almost 30% in February and March on Covid-19 fears, the benchmark index Nifty 50 bottomed out near 8,100 on 3 April 2020. Interestingly, on that day India’s daily new case count for Covid-19 had not hit even 500. Similarly, daily Covid-related death figures had not reached even double digits. At that point, the Nifty 50 rebounded and rose almost in a linear fashion over the next 11 months taking a breather only after crossing the 15,100 mark in February 2021.
All this while, India was engulfed in the first wave of Covid-19. The daily new case and daily death count rose exponentially despite a country-wide lockdown and peaked at 96,000 and 1,200, respectively, in September 2020. In a way, the market had the foresight that after the dust settled, the economy would rebound and corporate profits would revive to normalcy. There have been many such instances in the past—both for markets and sectors, as well as for stocks.
However, there are some chinks too, in the armour of the Efficient Market Hypothesis.
First, over long periods, there is a sizeable number of investors who have consistently delivered portfolio returns above their benchmark returns, in a way disproving the theory.
Second, with the release of any relevant information, the stock often moves erratically. For example, if a cement company announces a new project, the stock may go up as the news hits the tape. Understandably, the market here is taking the project as value accretive for the stock. However, the stock may dip the next day due to possible fears regarding deterioration in industry demand-supply dynamics with this project. Thus, it is not just about interpreting the new information correctly. Getting the fair value of a stock right depends more on conclusions regarding the future based on our comprehension of incremental data. It is this ability to formulate future outcomes ahead of others that provides an edge to some investors.
Third, there are times when a stock or market benchmark makes big moves without any new data point. Finally, if the market is efficient in pricing stocks, then dramatic changes where market indices move by more than 5-7% in a day ( e.g. on 19 October 1987, the USA’s Dow Jones index had fallen by 22%) should not take place.
Investors who invest directly in stocks knowingly or unknowingly believe that markets are inefficient—at least partially so. As above, there is ample evidence that this belief is correct. Further, that markets are only partially efficient means that at least some people can generate above-market returns. However, to achieve such returns, one needs to have proper understanding of the way markets work. On the other hand, a large proportion of investors underperform the benchmark. Markets being efficient to some extent make it extremely difficult to beat the benchmarks. Hence, investors who are unable to devote enough time and do not have some basic understanding of accounting and finance may be able to enhance their chances of wealth creation by investing in passive funds, or in good active fund management vehicles, rather than directly in stocks.
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