The Stock Market Is Getting Even More Efficient

There are two broad schools of thought when it comes to the stock market – one believes the stock market is efficient and the other says that it is inefficient.

Let’s first start with the hypothesis that the stock market is not efficient. These folks postulate that, within the stock market, it is possible the identify stocks that are undervalued. They thus can buy these stocks, wait for them to appreciate or gain in value, and then sell them at a profit. The theory behind this makes sense.

Then there are those who believe in the Efficient Market Hypothesis or EMH. These folks believe that there are not value/price anomalies that can be exploited within the stock market. Moreover, even if there were these anomalies present, the cost of exploring them (via transfer fees, taxes, etc) would wipe away any benefit. And maybe even end up costing the investor more in terms of lost returns.

What happens to these two groups of believers?

Well, like any group that really believes in something, they follow their beliefs with actions.

For believers in an inefficient market, they pursue active investing strategies with an end goal of achieving a return on their investment that is greater than the market index. The name of this extra return above and beyond the market index is called alpha. They are looking to beat the system.

Meanwhile, believers in the EMH do not pursue active investing. Instead, they pursue a passive investing strategy in which they do not seek alpha but instead seek index stock market returns. They are not so much looking to beat the system as just to benefit from it as a whole.

So who is right?

This could really turn into a big argument depending on who you ask. But all of the data comes out supporting the idea that the stock market is efficient. Any quest for alpha is not persistent, meaning it does not occur at a rate greater than that expected by chance. Moreover, oodles of data supports the idea that any potential benefit of the quest for alpha is more than wiped away by the associated fees and taxes.

Rather than rehash all of this data and these arguments, here are some previous posts that go through it all:

But wait there’s more…

The stock market keeps getting even more efficient

And it’s really active investors’ fault. Let me have economics professors Dwight Lee and James Verbrugge of the University of Georgia explain:

The efficient market theory is practically along among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear effect market anomaly is discovered, the behavior (or lack of behavior) that gives rise to it will tend to be eliminated by competition among investors for higher returns…

For example, if stock prices are found to follow predictable seasonal patterns unrelated to financially relevant considerations, this knowledge will elicit responses that have the effect of eliminating the very patterns they were designed to exploit…

The implications here are rather striking. The more empirical flaws that are discovered in the efficient market theory, the more robust the theory becomes…

In effect, those who do the most to ensure the efficient market theory remains fundamental to our understanding of financial economics are not its intellectual defenders, but those mounting the most serious empirical assault against it.

Ok, that was a lot. But also extremely impactful. So let’s take a moment to break it down here…

Basically, what Drs. Lee and Verbrugge are saying here is that a market becomes more efficient the more that you exploit any inefficiencies.

By adjusting behavior to any inefficiencies, you inherently begin to eliminate those very inefficiencies.

And on and on until there are none left. It makes a lot of sense.

So, maybe both active and passive investors are right in their hypotheses. It’s just that active investors are employing this strategy in the wrong time period. The stock market likely was inefficient. In the past. But now? Not so much.

Another conclusion, from the perspective of passive investors, is that we should be grateful for active investors. As passive investors, we benefit from their work making the market more efficient without having to pay their fees!

But why is this the case?

The biggest reasons that the market is so efficient are probably information and accessibility.

The widespread and immediate availability of information makes it so that just about every investor has access to any potential price/value anomaly in the market.

Then, just about every investor has access to the ability to trade immediately when these hypothetical anomalies pop up.

As a result, the value of the anomaly dries up just as soon as it welled up in the first place. The price reverts to accurately reflecting the market almost immediately.

Again, this may not have been the case in the early 20th century. But it is now. And to fight against it leaves you with a big problem.

The big problem

Fees and taxes.

Any attempt to exploit a price/value anomaly in the market will require an investor to buy or sell an investment, or both.

Good data shows that investors with higher turnover (not surprisingly men more than women) have lower returns. That’s because each transaction is associated with a tax hit (if not in a retirement account) and a transaction fee. Not to mention any lost value in the bid/ask spread of the sale.

On top of this is any fees paid to an investment manager since you will likely not be the one following every up and down in the market.

The result: even if you somehow generated some alpha, or return above the index, before taxes and fees, there is little to no chance that you beat the index after including taxes and fees.

Let’s bottom line this

Here are the conclusions:

The stock market probably was inefficient in the past
Attempts to exploit inefficiencies in the market actually end up making the market more efficient
As a result, today, the stock market is very efficient
Any attempts to exploit a perceived inefficiency is more likely to result in a net loss of returns
Passive investing via index funds is the recommended option to achieve higher net returns in the stock market

Take Buffet’s word for it when he said, “Buying an index fund over a long period of time makes the most sense.”

In the meantime, here are some insider looks at my own investment portfolio:

What do you think? IS the stock market efficient of inefficient? Why? Have you dabbled in active investing? How did it go? Let me know in the comments below!