Of Course Investors Can Beat the Market

by Stefan M.I. Karlsson

[Posted September 8, 2004]

Speculating in the stock market is a very popular activity. Millions of people do it regularly, and hundreds of millions of people around the world hire fund managers to let others trade for them. Yet, according to some economists, these people are just wasting their time. Sure, some of them might be lucky and earn a lot.  But just as many will lose because of their trading activity.

In the long run, only people who have as much luck as the Disney character Gladstone Gander will be able to profit in the stock market, they say. Ordinary people like Donald Duck and Daisy Duck, but also astute businessmen like Scrooge McDuck and his arch-rivals John D. Rockerduck and Flintheart Glomgold, are at best likely to earn the average return of the market.

In fact given that active trading is likely to be associated with transaction costs during the many trades, active trading is in fact likely to push people to below-average returns. And the loss for the average trader is of course compounded by the profits made by the Gladstone Ganders of the real world. Stock market trading is according to this theory nothing but a form of gambling.

This theory is known as Random Walk Theory or the Efficient Market Hypothesis (referred to as EMH from here on) with its foremost advocates being the economists Eugene Fama and Louis Bachelier. Instead of active trading, they recommend that everyone put their money in low-fee funds which monitor the stock market averages, so-called index funds. Since index funds do very little trading they are likely to have low transaction costs and can thus hold fees down which gives savers the highest return since they can´t beat the indexes (and accordingly the index funds) anyway.

The basic idea behind EMH is that because there are so many investors out there hunting for good investment opportunities there can be neither undervalued stocks nor overvalued stocks because if there were, investors would instantly rush to buy the undervalued stocks and sell the overvalued stocks until no under- or overvaluation existed any more. Of course, there is a lot of truth to this. Investors will certainly try to act in a entreprenurial fashion and bid up any stocks they see as undervalued and sell any stocks they see as overvalued.

However, the problem for EMH is that the process of adjusting stocks to its true value will only rarely happen instantaneously. Instead, for various reasons, this will take some time. In fact, if it did happen instantaneously there would be no reason for investors to try to bid up the stock as the profit opportunity would never arise. Given transaction costs, any such move would in fact be associated with a loss.

EMH also has a great paradox. In order for their scenario to occur then people will have to believe there are profit opportunities, but what EMH in effect says is that there are no profit opportunities! But if people believed there were no profit opportunities then there would be no one who would act to correct the discrepancy between fundamental value and current price. So a necessary -but not sufficient- condition for EMH to be true is if investors believe it is not true. The more people believe in it, the less true it will be. EMH must assume that people are completely irrational.

From this comes yet another paradox. For EMH to be true we would have to assume that investors are always extremely rational and well-informed. Otherwise they could not immediately find any discrepancies between stock prices and true value. But if they are engaged in such an allegedly futile activity as trying to gain from speculation then they could hardly be considered rational. After all, since they can make no profits given the immediate elimination of price discrepancies then it is not rational for them to be speculating at all. The very rationality that is needed for people to discover price discrepancies would lead them from the field of finding these discrepancies since they never appeared. (If they appeared then the speculators would make profits which EMH says they cannot receive).

The advocates of EMH are like people who say that there can never be any bills or coins to be found on the street because if there had been any money on the street someone would have picked it up. Yet if someone has picked up the money then these people would have been contradicted since the people who have picked up the money would have done what the other people said was impossible. Thus, the assumptions underlying the conclusion that there can be no money on the street or no profit opportunities in financial markets are in itself in direct contradiction with the conclusions they are supposed to prove!

The most fundamental error of EMH is that it uses the results of the entrepreneurial process (the elimination of discrepancies between fundamental value and current price) to deny the existence of the reason (the opportunity to make profits) for the existence of that process.

But even apart from that there is another related fundamental problem with EMH, namely that it rests on the absurd assumptions of the "Perfect Competion" model of markets, both in terms of assumptions about people´s knowledge and the impact of their trading on the market.

First of all, it is simply not true that people have full access to all relevant information and are fully rational in the sense of always using the information they do have in a optimal way. To be sure the market process gives a strong incentive for people to be as rational and informed as possible, but given the inherent limitations of the human mind we are unlikely to ever be perfect. This in turn means of course that there is always room for improvement. Astute entrepreneurs can always -if they are good- find new information and/or better ways to analyze the information.

The obviousness of this should be apparent when we consider the fact that since stocks are ownership titles for real corporations any claim that there are no entrepreneurial opportunities in the stock market would imply that there are no entrepreneurial opportunities in "the real world". An investor who buys a stock in a company which has a new approach for satifying consumer demand is in effect acting as an entrepreneur in the "real markets" in satisfying consumer demand. Of course, when that approach proves effective, other investors will move in, but this is no different than the fact that the effectiveness of the new approach will probably be emulated by the company´s competitors. And in both cases, it is to be expected that the more astute investors/companies will be there before competing investors/companies.

Secondly, there are several reasons to believe that prices will fluctuate according to factors unrelated to the performance of the companies.

To begin with, it is wrong to assume that investors will perceive the fundamental value to be equal, even assuming equal assessments on the prospects of a company. The fundamental value of a stock is of course in theory the present value of all future cash flows received by the owner of the stock. But the present value has to be discounted not by the risk-free interest rate, but by an interest rate which includes a risk premium. The risk premium demanded by investors to invest in a particular security will not only depend on their general risk aversion but also their assessment of just how uncertain they feel the future earnings are.

The average risk premium will fluctuate partially because the people leaving the markets have different risk aversions than the people entering the markets, but more importantly because people´s willingness to take risk fluctuates over time. During booms, when people feel that the economy is on a roll and when ideas of the arrival of a "New Economy" where the business cycle has been abolished thanks to the wisdom of men like Benjamin Strong and Alan Greenspan appears, they will have lower risk aversion than during periods of economic decline, lowering their required risk premium and raising stock prices. This will increase stock prices in general but most particularly stocks which have volatile earnings and earnings in a very distant future.

A similar effect comes when newly created money from a monetary expansion effects the stock market before the rest of the economy. A monetary expansion will not effect all prices in a similar way, but will raise some prices relative to others depending on who are the first receivers of the money and on what they spend them. And when the newly created money is spent on the stock market this will raise stock prices. Monetary expansions and the temporary booms they create are of course often responsible for the aforementioned over-optimism.

It might be argued that investors could always assess to what extent stock prices are raised through temporarily lowered risk-aversion and monetary expansion and sell stocks in response. But this ignores two things. Firstly, it is nearly impossible to exactly pinpoint the exact effect of these two factors. One can at best only roughly estimate such things. Secondly, and more importantly, it is not always true that the rational response from astute investors is to bid down prices. Often these two factors create "bubbles" which can carry on for years, which make it rational for investors to bid up prices they know are over-valued in accordance with the "greater fool theory".  For example when the talk of an overvalued stock market started to appear frequently, after Alan Greenspan´s famous speech of "irrational exuberance" in December 1996, the S& P 500 stood at 750 and the NASDAQ Composite at 1300. When the index reached its highest point in March 2000 the S& P 500 had doubled in value to 1527 and the NASDAQ had increased nearly fourfold to 5049.

This is particularly true when the bubble is supported (as it nearly always is) by a massive monetary expansion. If a bubble had been merely a case of over-optimism and the accompanying temporary lowering of risk-aversion then the flow of money into the stock market (or whatever market experiences a bubble) would raise interest rates which in turn would draw away money from the stock market and limit the extent of the bubble.

But, supported by a credit expansion, interest rates will not rise when money flows into the stock market, making it profitable for investors to borrow money at artificially low interest rates and use them to bid up prices they know are really too high. And since the bursting of a bubble is likely to be met with massive interest rate cuts, investors know that the risks with their bidding up of overvalued stocks are relatively limited.

Moreover, EMH ignores the effects of insufficient liquidity on the markets and relies on the notion of investors action having no effect on prices, like in the "Perfect Competition" models. But this is clearly not true. Particularly in assets which have a low trading volume, any move from a larger investor will strongly effect the price. If say a larger investor sees a small company whose stock is valued at $25 but whose fundamental value is $30, but who only has 100 shares per day in trading volume, then he will be unable to buy more than a few hundred shares without significantly raising the price and thereby eliminating his profit opportunities. This problem is compounded by the fact that when he wants to sell the stocks, his selling will cause a sharp decline in the valuie of the shares, particularly if he wants to sell them all at once.

Because of the fact that their sheer movement in and out of positions will effect the price in a way which substantially reduces their profits, larger investors will be unable to take advantage of many of the profit opportunities, creating discrepancies between fundamental value and actual price.

Moreover, whenever they need to withdraw money for reasons unrelated to market valuations (payment of taxes or other personal expenditures) this too will create an effect on prices unrelated to the market valuations as their sales lower the price significantly. Of course it could be argued that the withdrawal for consumption raises the natural interest rate and thus justifiably lowers the price, but clearly this effect will fall disproportionately on the specific assets they owned. This will also create short-term discrepancies between what people believe is the fundamental value and the actual price.

Because of all of these factors there will inevitably be discrepancies between the market price and the fundamental value, creating profit opportunities for investors even given the incorrect assumption that investors will be able to predict future profits or the probability of different profit levels perfectly. Because if the price for various reasons is below or above long-term fundamental value then speculators will be able to profit when the price returns to normal.

All of this is not to say that EMH is all wrong. They are right that in general speculation will move prices to the fundamental value. And they are also right when they say that most people will be unable to out-perform the market since after all "most investors" are the market.  They are also right that because of this it would be just as well for them to put their money in an index fund (assuming the stock market isn´t generally overvalued). But they are clearly wrong in saying that it is impossible for astute investors to gain money from speculation other than through sheer luck. While most fund managers won´t be able to beat the indexes, some smaller managers with superior abilities will be able to do that.

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Stefan M.I. Karlsson (email) is an economist currently working in Sweden. Comment on this article on the Mises Economics Blog. See also his archive.

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