Academic theories of financial markets often won’t make investors much money.
It’s always better to have a trading plan than a textbook in the market.
This Market Insights video explains how even theories that sound logical and appear to work sometimes aren’t useful for individual investors:
(If you’d prefer to read a transcript, click here.)
Thank you for joining me for a look at how finance professors are wrong in the way that they think about the stock market.
A broad, overarching trend in academic theory is the efficient market hypothesis (EMH).
Now, in general terms, the idea here is that individual investors — and that includes professionals — it’s individual market participants that form rational expectations about a stock.
In other words, like in economics, we believe decisions are rational. The function of the market is to take all of that information based on rational expectations and efficiently aggregate it into a single price.
This is the equilibrium price, or the current market price. That’s where the price is balanced between buyers and sellers, and it incorporates all of the available information about that particular security instantaneously.
Sometimes that theory seems to work well. We recently saw Pfizer announce news about its vaccine, and the stocks affected by the vaccine, which is almost every company in the economy, jumped higher.
This is a chart of Boeing.
Boeing has struggled with the pandemic simply because travel is perceived not to be safe by many. Travel restrictions take away even more potential customers.
So, airlines are cutting back. Boeing just isn’t seeing orders. But when Pfizer announced its vaccine, even if travel is still reduced, Boeing should have benefited. And that’s what we saw.
There was an instantaneous incorporation of that information into the stock price. And as traders, we call that a gap. So, we had a gap up.
The EMH is so important that it led to index funds. It implies it’s impossible to beat the market consistently simply because news is random and market reactions are random. So, as a group, investors are not able to beat the market.
And the idea for index funds is if you can’t beat it, join it. So, just become a participant in the index fund and don’t worry about beating the market.
Except that when the market goes down and loses 50%, you’ll lose 50%. And under the EMH, it’s OK if you lose 50% of your money.
Well, experts quickly realized that the EMH isn’t strictly true. Immediately, they began finding exceptions.
So, the theory got a little bit more complex, and we ended up with three forms.
The weak form says you can use fundamental information, forward-looking fundamentals and earnings estimates to beat the market.
Well, others found that wasn’t enough. So, the semi-strong form says, well, fundamentals aren’t going to work. Price action doesn’t work. You need inside information.
And the strong form says even with inside information, you cannot beat the market.
So, immediately after seeing the news come out that the EMH is in trouble, analysts and our professors developed new versions of it.
There are some challenges to the EMH. There are well-known market crashes, and then there are times when stocks simply form bubbles. Well, in an efficient market of any form, they should not happen.
There are also anomalies. Momentum persists. The stock that’s going up tends to keep going up. The stock that’s going down tends to keep going down.
And then there are seasonal anomalies. There’s the academic theory that January’s performance tends to beat the other 11 months of the year, especially in small caps. And there’s a tendency sometimes for end-of-the-month gains.
So, there’s a number of challenges. The EMH in practice seems to fail quite often.
This is a chart of Biogen, and it ran up sharply. It’s a large-cap stock with a 40%-plus gain on favorable rumors related to a drug to treat Alzheimer’s.
Within days, the Food and Drug Administration committee met and said it needs more information on this drug. So, we had this huge run up, and this huge run down. And the EMH says that’s simply not possible.
Price incorporates all the information. So, price ran up. It was incorporating approval. The approval should not have failed just two business days later.
The bottom line is that markets are unpredictable. Even if the EMH was true, the EMH is still saying that markets are unpredictable.
You need a trading plan that’s going to be better than an index fund because with the trading plan, you can mitigate losses. And a good plan will also keep you from chasing news.
So, trade based on defined principles rather than rumors or news, and don’t give up and believe that the EMH is correct and you should only be in index funds.
If you’re in index funds, you will lose in bear markets, and you will never beat the market. And there are plenty of examples of how it is possible to beat the market in the long run.
So, avoid the academic literature. Stay in the market if you want to be a good investor. Thank you.
Regards,
Editor, One Trade