Are markets efficient? Do stock prices discount all publicly available information, correctly and accurately? Is the only way to earn higher returns to take higher risk? It all depends who you ask. Academics who study and teach modern portfolio theory will say, “Of course markets are efficient.” But practitioners who put their money where their mouths are and make a living this way, they will say, “Of course markets are not efficient.”
If you side with academics, you must invest in index funds, and if you side with practitioners, you should invest in stock pickers and actively managed portfolios managed by portfolio managers who aspire to beat the index.
But are academics that different from, say, value investors? In fact, they are not. They both believe that markets are efficient in the long run. Where they disagree is whether the market is efficient in the short run. And if you look at it this way, one cannot seriously think that markets are efficient in the shorter term.
Market efficiency originated at the University of Chicago, where academics in the 1970s produced research which demonstrated that markets were efficient. Stock picking at that point started to lose its lustre. But fortunately for stock pickers, other academics in the 1980s started to produce research which showed that there were predictable patterns in stock prices, such as the January Effect and the “sell in May and go away” effect, and that different strategies produced unusually high returns even after adjusting for risk, such as the size effect, the value effect, the volatility effect and so on.
At the same time, other market participants also started to become vocal against market efficiency.
Respected value investor Martin Whitman of Third Avenue penned recently: “There is a belief that securities markets reflect price equilibrium … and prices of securities are right. What nonsense!”
Warren Buffett has indicated that he is willing to endow chairs to academics to teach market efficiency so that “more people would sell what he buys and buy what he sells.” Nobel Prize winner Robert Shiller once called market efficiency “one of the most remarkable errors in the history of economic thought.”
