To be clear, this is not a research paper, it is merely an article on modern finance. The field of finance has evolved drastically over the century and has witnessed many ups and downs. Numerous research papers and models have been published to understand the financial markets. Majority of people involved in finance focus on one aspect — maximizing returns and minimizing risks on investment.
Finance is considered to be both an art and science, according to Investopedia. Efficient Market Hypothesis (EMH) is a popular theory that asset prices will reflect all the information available to the public at that instant moment. Put it in simple words, it implies that markets prices are always efficient, and participants are always rational. The Capital Asset Pricing Model (CAPM) expands on the notion that price of an asset can be determined by factoring in systematic risk, risk-free rate and market premium compensating for the risk. CAPM seems to give a nice picture on how to price an asset. Systematic risk refers to beta, or put in simple words, the volatility of the stock compared to the market, and assumes volatility is a risk. Changing stock prices is a risk and its bad, apparently.
For EMH, the problem lies in the assumptions made, that the market participants are rational and market price reflect the real price of the asset. It is a simple theory, so why argue with it? The problem lies in the fact that people are not always rational, behaviour economic researchers have demonstrated repeatedly that markets can be subject to emotional and other bias of investors. EMH proponents do not even believe in the existence of the field of Behavioural economics. EMH denies the existence of a bubble and high prices are justified because investors know what they’re doing. In fact, the father of the Efficient Market Hypothesis, Eugene Fama, states that he hates the word “bubble.” Ironically, a year after his statement, the world entered into a financial crisis because of a so-called housing “bubble.”
CAPM is expanded from EMH, based on the statistical evidence produced that supports the theory. Warren Buffett’s investment strategy is completely opposite of CAPM and the model would not support the returns he made. For statistical reasoning, let us assume that his investment success is an outlier, which includes the entire group of value investors. According to CAPM, volatility is a risk that is weighed in the model, so higher volatility means higher risk. But when did volatility become such a bad thing. Without volatility, how can the price of your asset increase or decrease. If the risk of a security is focussed on the fact that the price changes too frequently rather than the fundamentals of the company, then there is no point of investors looking into balance sheets. Earnings reports should be replaced by volatility reports. The only way to make money with CAPM is reducing risk or buying fewer volatile stocks. Imagine buying a house because the price of house does not change too much, without ever looking inside or even knowing how many bedrooms there are.
The problem with EMH and other models associated with it, is not with the evidence but how it is interpreted. Asset prices only makes sense if they are somehow related to other asset prices. It ignores the obvious concern if whether asset prices should be based on fundamentals like earnings, which can actually affect the performance of the asset.
For simplicity purposes, let us get out from the world of finance and enter into a simple world that will be easy to make comparisons. EMH relies on assumptions that markets are efficient. Instead of the stock market, we will look into the auto market. Suppose there are two used cars — A and B-, that are identical. Suppose John buys car A for $20,000 because he thinks that is the fair value of the car, based on the fundamentals. According to EMH, and other models, I should buy car B for $20,000, because market prices are efficient, and participants are rational. Now, what if John is a doctor who does not know much about cars. The dealer sells cars A and B for $24,000 and John does not lower the price because he thinks that is the fair value and buys car A for $24,000. Now, EMH will likely determine that I should buy car B for $24,000 as well. To sum it up, Larry Summers, economic advisor in Obama administration, said that Ketchup economics “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and from this ketchup price is efficient, referring to EMH. When the housing prices were rising rapidly, disconnecting themselves from their fundamental values, experts referred to the EMH and denied that house prices will ever be inefficient or priced incorrectly. These experts were correct, until 2008.
The tech bubble, 2008 financial crisis and recent GameStop short squeeze reminds us that market prices will not always be efficient, unless you’re a EMH supporter. Despite the numerous real-world studies and research that questions the possibility of EMH, it is still practiced in mainstream finance, and is a major component in the finance curriculum. Instead of arguing with statistics, proponents of EMH should take the time to scroll through a subreddit on stocks and find the rationality in “diamond hands.”
You might wonder, if everyone is accepting EMH, then why try to question it. And it is fair to say that trillions of dollars of assets, derivatives and other securities are priced using these assumptions. If EMH is suddenly refuted, then the markets have to reprice all these securities and reprogram their algorithms to accommodate a new model. But there is no new model. So, the only option here is to stick to what is working, for now. If it is working now, does not mean it will work forever. Behavioural finance is still a debated field and involves less mathematical models than its peers. Instead, it relies on human psychology and their behaviour. Humans can have emotions, bias, addictions and other factors that can distort them from making a rational decision. You can see the limitations of the human mind once they enter a casino and continue gambling for a while. Then why consider markets to be “efficient” and “rational” especially in the world of Robinhood. It will take decades for EMH to be replaced with a more consistent and relatable model that investors can use.
