Efficient Market Hypothesis

Is efficient market theory becoming more efficient? 5/27/17

Article: ""Quants and quirks"     

 >The Efficient Market Hypothesis states that all current information regarding a stock is already built into the stock’s current price. Predicting future stock price movements would require access to future information, which is impossible, meaning that stock price changes cannot be predicted. The Dow Jones lost 23% of its value in a single day (October 19, 1987 - Black Monday). Economists like Robert Shiller won a Nobel Prize by demonstrating that the market’s movements were far more volatile that was considered possible under the EMH.

> A new trend is towards “smart beta”.The beta calculation is essentially a comparison between the movements of an individual stock (or portfolio) and the movements of the market as a whole” (page 210). Once unsystematic risk has been eliminated from a portfolio through diversification, any risk that remains is the market risk or beta. If we assign a beta of one to the market overall, then a stock with a beta of 2 will go up by 20% if the market rises by ten percent. By the same logic, a stock with a beta of 0.5 will only fall 5% if the overall market drops ten percent. The higher the beta, the more volatile the stock and the greater it will reflect any movement in the overall market. Some investors believe even higher returns can be obtained if the total stock market fund is tilted in favor of some strategy or “flavor”. For example, tilt the fund in favor of “value” stocks (stocks with low P/E ratios and low prices relative to book value). Since the tilt happens as the fund is being set up, the fund is passive and trading is minimized. And systematic risk will still be diversified away. But returns (they claim) will be enhanced. Tilting a total stock market portfolio in the direction of one of these strategies is known as a smart beta strategy.

> In that it requires a lot of time and analysis (which costs money) to uncover such “smart beta” strategies, Antti Ilmanen argues that markets are “efficiently inefficient”. Individuals can’t beat the market but large firms with capital and computing power can.

> Andrew Lo of MIT has proposed an “adaptive markets hypothesis” in which markets change in an evolutionary manner. Successful investment strategies persist while unsuccessful ones lose money and fade away.