Here at rockwealth, we advocate evidence-based investing. But what exactly does that mean? Well, to some degree, most financial advice businesses try to predict the future. They aim to identify specific investments they think will outperform. We don’t. Instead, our investment philosophy is based on peer-reviewed evidence and a few important principles developed over the last 75 years or so by financial academics. One of those principles is market efficiency.

In the world of finance, few theories have garnered as much attention and debate as market efficiency, or the Efficient Market Hypothesis (EMH) as it’s more formally known. 

For the uninitiated, the term might sound like complex jargon, but its implications for investors are very significant. In this article, we’re going to demystify market efficiency, trace its historical roots, and highlight the lessons it holds for those looking to navigate the financial markets.

 

Shares are priced fairly

At its core, the theory of market efficiency posits that financial markets are “efficient”. In simpler terms, it suggests that, at any given time, share prices fully reflect all available information. This means that shares are always traded at their fair value, making it impossible for investors either to buy shares that are undervalued stocks or sell shares for inflated prices. As a result, it’s actually very hard to outperform the overall market through expert stock selection or market timing.

 

How the theory developed

Although market efficiency is generally assumed to be a relatively modern phenomenon, stock markets have been hard to beat for a very long time. In the mid-nineteenth century, a famous New York stock operator named Daniel Drew said that it was only by acting on inside information that you could outperform your peers. “To speculate on Wall Street when you are no longer an insider,” he once remarked, “is like buying cows by candlelight.”

Insider trading was banned in the US in the 1930s (though not in the UK until 1980), and beating the market became even harder. A US study published in 1940 noted that, even before fees were factored in, the average professionally managed portfolio underperformed the broader stock market.

It was the advent of computers that confirmed beyond doubt that identifying either undervalued or overvalued stocks was extremely difficult. The renowned economist Eugene Fama is often credited with formalising the Efficient Market Hypothesis in his 1970 paper, Efficient Capital Markets: A Review of Theory and Empirical Work. 

Fama categorised market efficiency into three forms:

Weak Form Efficiency: Share prices reflect all past publicly available information, including past trading volumes and stock price patterns. This suggests that technical analysis, which relies on past stock price data, cannot consistently yield superior returns.

Semi-Strong Form Efficiency: Share prices adjust rapidly to new public information. This means that neither technical nor fundamental analysis (which evaluates a company’s financial health) can consistently produce excess returns.

Strong Form Efficiency: Share prices reflect all information, both public and private. If markets were strongly efficient, even insiders with confidential information can’t achieve superior returns.

 

Reasons for market efficiency

So why are stock markets efficient? You could argue that it’s down to a mathematical concept called the wisdom of crowds, which shows that creating a better-than-average estimate of an uncertain value — in this case the value of a stock or a bond — becomes more difficult as the number of estimates increases. 

If market participants have access to the same information, the total estimates above the actual amount tend to cancel out those below it, and the average comes remarkably close to the real number.

Another reason for market efficiency is that the asset management industry has grown hugely in recent decades and continues to do so. The more financial professionals there are, each of them trying to outdo one another, the harder it is for any one investor or fund manager to outperform.

 

Three lessons for Investors

The implications of market efficiency for investors are profound. Here are three key takeaways:

Diversify your investments

Because it’s so difficult to identify, in advance, which shares, sectors or countries will outperform, it makes sense to diversify your investments. You can do this by investing in a passively managed fund that tracks the overall market, or one that tracks a specific sector, or a fund that contains all the publicly owned companies in a particular country or region.

Control your fees

If markets really are efficient, then it’s highly unlikely that you or your chosen fund manager have the skill or knowledge to pick the right shares at the right time with any consistency. But one thing you can do to improve your long-term net returns is to reduce the amount you pay in fees and charges. So instead of focusing on how a fund has performed in the past, look at how much it costs to invest in the fund.

Manage your behaviour

If markets are efficient, spotting when a specific share, or the market as a whole, is either undervalued or overvalued is a pointless exercise. Remember, every trade you make costs you money. So another way to maximise your returns in an efficient market is to manage your behaviour and simply do less. In other words, don’t be tempted to try to second-guess the market. Just keep investing on a regular basis and focus on your long-term goals.

 

Conclusion

Ultimately, the Efficient Market Hypothesis is just that, a hypothesis. Sometimes the “crowd” does get it wrong, and that’s why we occasionally see market bubbles.

But you don’t need to believe in Strong Form Efficiency — i.e. that markets are perfectly efficient — to find the principle of market efficiency a useful one. The point is that the market is efficient enough for rational investors to accept that they’re unlikely to beat it and to settle instead for capturing the market return.

In the long run, diversifying broadly, controlling your costs and having a long-term perspective really do make sense.

 

FIND OUT MORE

Want to find out more about evidence-based investing and how rockwealth Norwich can help you to achieve your financial goals? Then give us a call or send us a message. We would love to hear from you.

 

© rockwealth MMXXIII

Financial Planner in Norwich

rockwealth Norwich is an evidence-based and fee-only Financial Planning firm situated in the City of Norwich, Norfolk.

About: rockwealth Norwich IFA, is based in the centre of Norwich. As an independent financial planning adviser, we can help with many financial services, from independent financial advice, pension and retirement advice, investment advice and inheritance tax planning.

Interested to work with us?: We offer an Initial Discovery Consultation, completely free of charge and without any obligation. You can visit us at our office, schedule a video call, or call us on:  01603 542080.

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