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Deconstructing Efficient Markets and constructing optimal investment portfolios

Do you think markets are efficient? Think again. The institutions have made markets crazy, that’s an opportunity for you. The passive investing bubble is upon us.

The Efficient Market Hypothesis is an academic theory which postulates that all publicly available information is priced in the markets, and that no one can over-perform the markets or beat the indices. According to this hypothesis, stocks always trade at their “fair value” and that it’s impossible to buy cheap and sell dear. We disagree.

This theory gained traction in the 1950s, even though it existed long before that, and has greatly influenced every corner of financial markets.

It has in many ways supported the massive trend towards “passive investing” and reinforced the prevailing idea that an investor is hopeless against the big investment managers, banks and computer algorithms that are supposedly – all knowing. It has influenced the minds of individual investors and caused them to increasingly outsource their investments by surrendering their capital to the big and powerful investment managers.

This introduces a principal-agent problem in the markets which has resulted in a number of significant shifts in market structure. For example, it has increased the influence of career risk in markets, as investment professionals try to secure their jobs and management fees – rather than optimise their investor’s portfolios. Hand in hand with career risk are misaligned incentives and conflicts of interest. The incentives of the principal (the investor) and the agent (the investment manager) are misaligned. 

Generally, the principal wants his capital to be invested in an optimal and forward-looking way, as per his investment objectives. On the contrary, the agent wants to keep his portfolio volatility as low as possible and makes decisions to avoid ever having to look like a fool to his clients (he optimises a reduction in career risk), even if that sacrifices long term investment returns.

Due to these institutional constraints portfolio managers tend to use share price movements as a measure for risk and a signal of true value. Using price as a signal of value, rather than your own analysis, makes you short-term oriented and more of a speculator and less of an investor.

Even after all these obvious side-effects, the dogma of efficient markets still plagues the minds of investors. Not only has this theory been falsified time and time again, but an observant student of the markets can list a myriad ways in which markets are far from efficient.

Firstly, markets reflect the emotions of the humans that participate in those markets. This makes markets susceptible to all fallacies and traps of human misjudgment. Their fears, worries and anxieties – their greed, envy and crowd mentality. These are just a few human traits that make market efficiency an impossibility.

On top of that, humans suffer from fallible cognitive decision making under uncertainty, which causes them to buy high and sell low.

The psychology of time also plays an important part in the forces that serve to misprice securities. We believe this is expressed in the real world via the phenomenon of exponential discounting. 

Exponential discounting is when humans overvalue the present and undervalue the future by much more than logic would dictate. This gives rise to the opportunity for time arbitrage – which is the opportunity to buy a security at a discounted price because of short-term uncertainty that causes selling for non-fundamental reasons.

To compound all of the above confusions and inefficiencies, markets live under the spell of the institutional imperative. A sort of magnet which attracts institutions to invest in the same way, no matter if it makes investment sense or not, but also a deterrent which prevents them from investing in places where we consider to be very lucrative, because of the same dogmatic mindset.

It seems that they keep forgetting that it’s not what you buy, but the price you pay for it that makes the returns.

Living proof to the fact that investors continue to follow what does not make sense, is the great faith in credit rating agencies which continue to influence investment decisions while they fail time and time again to serve the point of their existence.

Due to all of the above market forces, investors move pro-cyclically when they shouldn’t (they buy high), and sell when they can’t take any more pain (which is the point of highest opportunity).

Around that point, when securities are selling on the cheap, the sophisticated investor swoops in to buy – knowing that risk is not equal to volatility – and that the lower the price the better (and not the other way around).

Using these market bipolarities and whims, one can systematically rotate his portfolio to better bargains than the ones he is holding, further compounding his returns in the process.

In this high pressure game of continuous twists and turns, it pays to keep a solid mindset and objectivity.

As the worry of the season dissipates, and markets and investors realise that you can’t have a deep recession every six months, markets will start moving up attracting liquidity and becoming less of a bargain. Then, returns achieved by those that invested at lower prices will make it obvious that an investor should seek to buy high quality assets at low prices using a long-term investment strategy.

The best returns are achieved by investors that have mental flexibility and are not prisoners to dogmatic or authoritarian views. These are investors that are ready and willing to invest, when their analysis tells them it is time to do so, even if the herd is not behind them or cannot understand their thinking at the time.

“All you need is a few big winners during your lifetime to beat the market. Everyone else will say you got lucky, but everyone else didn’t have the discipline to find them, buy them, and hold them.”

-Ian Cassel