“Investing in a Market Where People Believe in Efficiency Is Like Playing Bridge with Someone Who Has Been Told It Doesn’t Do Any Good to Look at the Cards”.



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AN ESSAY ON CAPITAL MARKETS, INVESTMENT AND FINANCE “Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards”. Discuss. Warren Buffet, New York Times Magazine. AUTHOR: CHARLES EKWE RUO “In an efficient market, security (example shares) prices rationally reflect available information” (Arnold 2005, p. 684). The efficient market hypothesis EMH) refers to share price movement with respect to available information and thus no trader will be presented with an opportunity of making supernormal profits (except by chance), therefore their profits on a share will reflect the riskiness associated with that shares (Pike and Neal 2009). However, “detailed investigations using advanced econometric techniques, larger data sets, increasingly powerful computing ability, and alternative theoretical models have in the last few years revealed a range of anomalies when the unpredictability-of returns hypothesis is tested.

Financial markets are often predictable to some extent, but the crucial question is whether this predictability can be exploited to make excess profits from trading in the markets? (Mills 1992, as cited by Coutts, 2000, p. 579). Warren Buffet, known as one of the most successful investors in history, is convinced that stock markets are inefficient. ”I think it’s fascinating how the ruling orthodoxy can cause a lot of people to think the earth is flat.

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Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards” (Buffet, 1984, as cited by Davis, 1990, p. 4). Buffet is referring to the fact that market price movements are often caused by emotional purchases and sales of stocks, resulting to an inefficient market, in other words, irrational market prices (Buffet, 1984). However, there are financial economists who see it the other way round.

They agree with the “Efficient Market Hypothesis” which states that security prices rationally reflect only available information (Arnold, 2005, p. 684) (see fig 1) therefore inhibiting the possibility of beating the market. According to this theory, there does not exist under- or overvalued shares, only true and fair values. It is difficult to say which side is right and which side is wrong, as both are based on logical reasoning and transparent facts. This paper will therefore, evaluate both concepts using different theories 2 nd ideas from those for and those against the EMH in order to find a conclusion which is reasonable and flexible enough to support a constructive point of view (based on pragmatism) and to better understand if Buffet? s statement is true or false or maybe both. A well-known story mocks the EMH: A financial professor was walking along a busy corridor with a student on his way to a lecture on EMH. The student noticed a 100 dollar note lying on the floor and stopped to pick it up, the professor says, ? Don‘t bother—if it were really a $100 bill, it wouldn‘t be there. The story well illustrates what financial economists usually mean when they say markets are efficient. Markets can be efficient in this sense even if they sometimes make errors in valuation, as was certainly true during the 1999-early 2000 internet bubble (see fig. 5) Markets can be efficient even if its participant? s show irrationality and stock prices exhibits greater volatility than can be explained by fundamentals such as earnings and dividends (Malkiel 2003). The origin of EMH can be traced back to the work of two individuals in the 60s: Eugene F. Fama and Paul A.

Samuelson who developed the concept of market efficiency from two different angles. In contrast to Samuelson? s direction of research, Fama? s (1963; 1965a; 1965b, 1970) seminal papers were based on his interest in measuring the statistical properties of stock prices, and in resolving the debate between technical analysis (the use of geometric patterns in price and volume charts to forecast future price movements of a security) and fundamental analysis (the use of accounting and economic data to determine a security? s fair value) (Lo 2004). Fama (1970) developed three grading systems to explain market efficiency.

These were based on three different forms of investment approaches which were designed to produce abnormal returns (Arnold 2005). 3 Weak form efficiency; current share prices reflect all information contained in past price movements and its represented as: Pt = Pt -1 + expected return + random errort. The expected return is a function of a security? s risk and the random component is due to new information, which by definition arrives randomly; hence, in a weak form efficient market, stock prices follow a random walk ,that is cannot be predicted (see fig. 2) (Hillier et al 2010).

Semi-Strong form efficiency; security prices reflect all publicly available information (examples are historical price, annual reports, mergers, dividend payment, earnings . etc) (ibid). Strong form efficiency; security prices reflects all information (public and private (inside) information). Note that in strong form efficiency, trading on inside knowledge is illegal because it makes outsiders feel cheated (Brigham and Houston 2009). Investments analysts who want to determine the intrinsic worth of shares based on underlining information undertake fundamental analysis, which according to Pike and Neal (2009,p. 6) “is the analysis of the fundamental determinants of company financial health and future performance prospects, such as endowment of resources, quality of management, product innovation record etc?. Furthermore, they argued that in EMH, fundamental analysis will not identify under- priced shares unless the analysts can react faster than others on release of new information or they are involved in inside trading (Pike and Neal 2009). Warren Buffet certainly disagrees with this notion and has consistently indicated (with his success as evidence) that he and his colleagues can make money in the market by identifying undervalued shares/stock.

Such financial analysts/investors with highly analytical skills do earn their living by consistently examining the fundamentals of stocks, in the hope of spotting an inefficiency via an over/under priced stocks/shares, example dividend payment, forecasted 4 sales, P/E ratio, merger/acquisition, change in employment policy etc. (Coutts 2011). An example was indicated by Coutts (2011) in his lecture on Capital Assets Pricing Model: If an asset has a [beta/expected return] combination on the Security Market Line (SML), the asset is fairly priced.

If the [beta/expected return] combination of an asset is above the SML, the asset is under-priced (has a high return for its beta). If the [beta/expected return] combination of an asset is below the SML, the asset is overpriced (has a low return for its beta). Competition among investors will tend to force stocks‘ [beta/expected returns] towards the SML (Please see Fig. 3 & Appendix 1). However, what is efficient to one investor could be inefficient to another because he/she can interpret the information better (Warren Buffet for example). Another approach is technical analysis which according to Pike and Neal (2009, p. 6) “is the detailed scrutiny of past time series of share price movements attempting to identify repetitive patterns? – this concept relates to Chartists who rely on graphs and charts of price movements. These highly skilled analysts aim is to spot inefficiency in the market and exploit it for huge financial gains. According to Chew (1993), studies have identified apparent market inefficiencies on specific markets at particular times examples are the weekend effect, in which there appear to be abnormal returns on Friday and relative falls on Monday.

The January effect for example, (see fig 4) occurs when share give excess returns in the first few days of January (see Appendix 3). ?The problem with placing too much importance on these studies for real investments is that the moment they are identified and publicized ,there is a good chance that they will cease to exist? (Arnold 2005,p. 702). Furthermore, they indicated that even if the effects are not eliminated, trading strategies based on 5 these findings will be no more profitable than buying and holding a welldiversified portfolio because of the high transaction cost involved.

The evidence of calendar effects is real and is identifiable and persistent (continual) as indicated by Mills and Coutts (1995), even though these calendar effects (trading month effects, seasonality, holiday effect) may have three of the attributes, they are not Material, that is. , net of transaction costs, trading on these anomalies, will not yield an abnormal return (Coutts 2000) – see Appendix 2. Other empirical challenges to market efficiency are size – shares of smaller firms outperforming shares of larger firms over a long period (see fig. 5). Also, crash and bubbles (see fig. ) refers to the US market crash of 1929 and 1987 which shows that sometimes security prices can move wildly above their true value and when prices fall back to their original value, investors lose lots of money (ibid). Coutts and Cheung (2000) paper on trading rules and stock return was used to shed light into market anomalies, and they cited Hudson et al (1996, p. 1131) “technical trading rules have predictive ability if succinctly long series of the stock indices are considered. However, the length of time needed to make returns may question the sustainability of the trading rules as practical investment tools?.

This argument concurs to the view of the professional investor Victor Niederhoffer (1997) who argued that “results that appeared significant in one period had a tendency to evaporate in subsequent periods? (p. 278). In fact, Victor Niederhoffer is highly sceptical of academic research and believed that it is highly unlikely to make profits from published inefficiencies (Coutts 2011). The point in this argument is that when information are made public, lots of traders move fast and trade with the same information and market will adjust rapidly, thus not allowing room for supernormal profits.

Furthermore, ”shares with low price earnings ratios (PERs) should be no more likely to be undervalued or overvalued than shares with high PERs, both groups 6 have an equal chance of being wrongly priced given future economic events on both the upside and downside” (Arnold 2005,p. 685). However, there are some investors who have rejected the concept of the EMH and have achieved supernormal profits examples (as cited by Arnold 2005) are: Peter Lynch (Fund grew from assets base of 18million dollars to 14billion dollars).

John Neff (each dollar invested in 1964 had returned 56 dollars by 1995). Benjamin Graham, Warren Buffett and his long time friend Charles Munger. Warren Buffet in the „Superinvestor of Graham-and-Doddsville indicated how he and his colleagues consistently beat the market by prudently picking undervalued shares and thus exploit the opportunity for supernormal profits. I‘m convinced that there is much inefficiency in the market. These Graham-and –Doddsville investors have successfully exploited gaps between price and value (Buffet 1984). Buffett is renowned as a disciple of Benjamin Graham, widely regarded as the father of modern securities analysis. Graham believed that the stock market is a highly irrational place where most participants brainlessly purchase stocks as prices rise and brainlessly sell them as prices fall. The disciplined, rational Graham investor seeks out stocks – Buffett calls them ”sleeping beauties” – that are selling substantially below book value (redefined by Graham to eliminate good will and accounts receivable). When the market eventually corrects its mistake, the investor takes his profit” (Davis, 990, p. 1). Graham? s philosophy is to focus on the difference between a firm? s market price and its discounted book value, providing an all important margin of safety that will protect the original investment and assure future profits (Davis 1990). Furthermore, Buffet began to analyze companies in his own analytical way, instead of relying simply on book value. “His investment ideas come from reading annual reports, the financial press and trade magazines. He determines the ”intrinsic value” of a business by 7 udging management’s ability to allocate capital intelligently and by analyzing the outlook for the company’s products and its industry. He arrives at the dollar value of the business by computing its future cash flow, allowing for inflation and interest rates? (Davis, 1990,p. 4). Warren Buffet said: I‘m convinced that there is much inefficiencies in the market…When the price of a stock can be influenced by a ? herd‘ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally.

In fact, market prices are frequently nonsensical…There seems to be some perverse human characteristics that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It‘s likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish (Buffet 1984). In conclusion, this paper has critically evaluated the EMH, objectively evaluated the evidence for and against EMH.

Even though stock market exhibit inefficiencies in some areas, especially at the strong–form level, we still believe that market is efficient as it is rare for an investor without inside information to consistently outperform the market (due to factors like transactions costs, there is no strategy that is available which can consistently yield abnormal return). Furthermore, it is true that some investors with superior analytical capabilities, extraordinary knowledge and creativity can make supernormal profits. However, we can argue that financial markets are efficient and will not allow investors to earn above-average risk-adjusted returns.

In short, we believe that $100 bills are not lying around for the taking, either by the professional or the amateur investor. When playing „bridge? a prudent player should look at his/her cards because there is information contained in them. In share prices, Warren Buffet is saying that one will see information by looking at the fundamentals, P. E ratio, earning 8 per share etc. In fact, what is inefficient for Buffet can be efficient for the normal investors because the investor should be able to interpret the information (Coutts 2011).

Furthermore, it is true that Warren Buffet has consistently made supernormal profits trading in equities; we conclude that he either has superior information, or he is using his highly analytical abilities to interpret the available information in a most favourable manner. 9 References Arnold, G (2005) Corporate Financial Management . 3rd ed, London: FT/ Prentice- Hall. Brigham, E. & Houston, J. (2009) Fundamental of Financial Management, 12th Edition South-Western: Cengage Learning. Buffet, W. E. 1984) The Superinvestors of Graham-and Doddsville USA: Columbia University Chew, D. H. (ed) (1993) The New Corporate Finance New York: McGraw-Hill. Coutts, A. J. (2011) Lecture on Stock Market regularities and Market Efficiency, Capital Market Investment and Finance Module, Second Year Undergraduate Course 2010/11, University Of Bradford School Of management, 08/02/2011. Coutts, A. J. (2011). Lecture on Capital Asset Pricing Model, Capital Market Investment and Finance Module, Second Year Undergraduate Course 2010/11,University Of Bradford School Of management,15/03/2011.

Coutts, J A and Cheung K -C (2000) Trading Rules and Stock Returns: Some Preliminary Short Run Evidence from the Hang Seng 1985-1997 Applied Financial Economics, 10, 579-586. Coutts, J A and Cheung K -C (2000) Trading Rules and Stock Returns: Some Preliminary Short Run Evidence from the Hang Seng 1985-1997 Applied Financial Economics, 10, 579-586, p. 579. Davis,L. ,J. (1990) Buffet Talks Stock, The New York Times Available on http://query. nytimes. com/gst/fullpage. html? res=9C0CE6D9173BF932A35757C0A96695 8260&scp=1&sq=buffett talks stock by L. J. Davis 1990&st=cse&pagewanted=4 [Accessed 04-03-2011] Fama, E. 963. Mandelbrot and the stable Paretian hypothesis. Journal of Business 36, 420–29. Fama, E. 1965a. The behaviour of stock market prices. Journal of Business 38, 34–105. Fama, E. 1965b. Random walks in stock market prices. Financial Analysts Journal 21, 55–9. Fama, E. 1970. Efficient capital markets: a review of theory and empirical work. Journal of Finance 25, 383–417. Hillier,D. ,Ross,S. ,Westerfield,R. ,Jaffe,J. &Jordan,B. (2010) Corporate Finance UK: McGraw Hill. 10 Lo, A. 2004. The adaptive markets hypothesis: market efficiency from an evolutionary perspective. Journal of Portfolio Management 30, 15–29.

Malkiel, B,G (2003) The Efficient Market Hypothesis and its Critics CEPS working paper no. 9 Princeton University Mills, T C and Coutts, J A (1995), “Calendar Effects in the London FT-SE Indices”, The European Journal of Finance, 1, 79-93. Niederhoffer ,V. (1997) The Education of a speculator New York: John Wiley Pike, R. & Neal, B. (2009, P. 416) Corporate Finance and Investment: Decision and Strategies London: FT/ Prentice- Hall 11 Figure 1 – A Description of Efficient Capital Markets Source: Dollery (2010) SOM 12 Figure 2 – Evidence of Weak Form Source : Dollery (2010) SOM 13

Figure 3:Graphical Representation of the Security Market Line Graphical Representation of the Security Market Line ri ? rf ? b i ( RM ? rf ) ri ? rf ? 2( RM ? rf ) rM 1 ri ? rf ? ( RM ? rf ) 2 M Market Risk Premium Risk Premium for a stock twice as risky as the market rf Riskless return Risk Premium for a stock half as risky as the market 0. 5 1. 0 2. 0 b Source: Coutts(2011), SOM. Appendix 1. What does the SML tell us? • The required rate of return on a security depends on: – the risk free rate – the “beta” of the security, and – the market price of risk. • The required return is a linear function of the beta coefficient. All else being the same, the higher the beta coefficient, the higher is the required return on the security. Source: Coutts (2011), SOM. 14 Figure 4 – January effect (in the U. K) Source http://markets. ft. com/tearsheets/performance. asp? s=572009 15 Fig 5 – Empirical challenge to market efficiency-Size 16 Fig 6 – Crash and Bubble Source: Dollery (2010) SOM 17 Appendix 2 – Calendar Effects Mills and Coutts (1995), in their empirical research on calendar effect on stock prices concluded that : ? Broadly support similar evidence for various countries for the ‘January’, ‘weekend’, ‘half of month’ and ‘holiday’ effects. ? ? Due to dividend effects – tentative conclusions! Explanations ? trading volume data, timing of information release. Fundamental question “How can this information be translated into improved portfolio performance? ” ? ? Even if persistent in timing and magnitude ‘trading rules’ may be prohibitive. ’round trip’ transactions costs render ‘market timing’ strategy unprofitable consistent with notion of market efficiency. ? ? No strategy available which consistently yields abnormal returns!! Documented ‘regularities’ may only have practice value for investors planning to trade; committed agents therefore only incur cost of ‘timing the trade’.

Authentic v Identifiable v Material Persistent X v Source: Mills and Coutts (1995) 18 Appendix 3 – Anomalies Calendar Effects (linked to a particular time are Weekend Effect (lower returns between Friday close & Monday close) called calendar effects. Some of the most popular calendar Turn-of-the-Month Effect (stock prices rise on the last effects include the weekend effect, the turn-of-the-month trading day of the month + first three trading days of next month) effect, the turn-of-the-year effect and the January effect Turn-of-the-Year Effect (increasing trading volume + (ibid). : higher stock prices in last week of December & first two weeks of January) January Effect (Returns are higher during January) Trading Month Effect (positive returns only in first half of trading month) Holiday Effect (lower returns on a holiday) Small Firms Outperform The first stock market anomaly is that smaller firms (that is, smaller capitalization) tend to outperform larger companies Insider Transactions There have been many studies that have documented a relationship between transactions by executives and directors in their firm’s stock and the stock’s performance.

Insider buying by more than one insider is considered by many to be a signal that the insiders believe the stock is significantly undervalued and their belief that the stock will outperform accordingly in the future. Low Book Value Extensive academic research has shown that stocks with below-average price-to-book ratios tend to outperform the market. Numerous test portfolios have shown that buying a collection of stocks with low price/book ratios will deliver market-beating performance.

January Barometer The January Barometer applies to all stocks, most of the time. It is simply stated, “As January goes, so goes the year. ” It has been reported that there have been only 5 times since 1950 when it has not held true. Presumably, this is because of the passage in 1933 of the 20th “Lame Duck” Amendment to the Constitution, which moved Inauguration Day from March 4 to Jan. 20, when newly elected federal officials take office. http://schwert. ssb. rochester. edu/hbfech15. pdf Source: 19 20

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