The Efficient Markets Hypotheses

The dominant orthodoxy in finance over the past seventy years is the Efficient Markets Hypotheses. Developed by a varied group of US academics from the early 1950’s, some of whom subsequently received Nobel prizes for their efforts, the key conclusion of this orthodoxy is that trying to beat financial markets is a fool’s errand.

In practice, this has been borne out by many studies over many time periods. As neatly summarised by the academic and investor Bruce Greenwald in his book, ‘Value Investing: From Graham to Buffett and Beyond’: ‘approximately 70 per cent of active professional investors have done worse than they would have by adhering to a passive strategy of simply buying a share of the market as a whole – a representative sample of all available securities.’

Unsurprisingly, investor preference for passive versus active strategies continues to grow:

Active v Passive since 2009

In addition, the fact that the higher cost of paying for active management necessarily tilts the average outcome in favour of the passive alternative, clinches the argument for many:

Zero-sum game & the Impact of Costs

Clearly, beating the market is not easy. In the salty words of Charlie Munger, the long-time business partner of Warren Buffett: ‘It’s not supposed to be easy. Anyone who finds it easy is stupid.’

Despite the uphill challenge, the stunningly successful investment track records of Munger, Buffett and other active investors suggest that the market can be beaten. Moreover, they highlight the materially significant reward for those that succeed.

The extraordinary power of compounding is central to that reward. For illustration, a 3.5 per cent annual return for 50 years produces an increase in wealth by a factor just shy of 6. By comparison, a 7 per cent annual return for 50 years produces an increase in wealth by a factor of almost 30. The greater the excess return, the longer the time-period, the increasingly greater the impact on long-term wealth.

Crucially, the attempt to beat the market is not always foolhardy. There areinefficiencies in the behaviour of market economies and the financial markets embedded within them. To benefit from the long-term power of compounding, the active investor has a strong incentive to exploit them.

The Financial Instability Hypotheses

In a provocative speech in 2012 looking to draw lessons for regulators from the global financial crisis, ‘The Dog and the Frisbee’, Andrew Haldane of the Bank of England succinctly set the context:

‘Modern macroeconomics has its analytical roots in the general equilibrium framework of Kenneth Arrow and Gerard Debreu. In the Arrow-Debreu framework, the probability distribution of future states of the world is known by agents.

Modern finance has its origins in the portfolio allocation framework of Harry Markowitz and Robert Merton. This Merton-Markowitz framework assumes a known probability for future market risk.

Together, the Arrow-Debreu and Merton-Markowitz frameworks form the bedrock of modern macroeconomics and finance. They help (purport?) to explain patterns of behaviour from consumption to asset pricing and portfolio allocation.’

The period from the end of the Cold War until the onset of the global financial crisis seemed to validate the modern macroeconomic framework, and its close cousin, the Efficient Markets Hypotheses. The march of globalisation, technology, financial innovation and free-market ideology seemed to have produced a great moderation in the behaviour of the global economy.

For global financial markets and policymakers, the tantalising prospect in the words of then UK Chancellor, Gordon Brown, that ‘we have eliminated boom and bust’ finally seemed more than a theoretical aspiration. The conviction that financial markets are the rational and efficient discounters of all public information grew in parallel.

The following quote from Nobel Laureate in Economics Robert Lucas, in his Presidential Address to the American Economic Association in 2003, gives a good flavour for the extent to which this framework and its implications had gained wide acceptance:

‘My thesis in this lecture is that macroeconomics in its original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.’

When this optimism proved delusional and the most serious financial and economic crisis since the great depression erupted, the need for a more realistic framework was laid bare.

The Financial Instability Hypothesis of long neglected US economist, Hyman Minsky, first published in 1975, gained a fresh following as a more plausible description of how a dynamic market economy behaves in practice.

In particular, the characterisation by Minsky of the macro economy as a system prone to bouts of dramatic instability generated endogenously by the financial system, chimed well in the dramatic days up to and after the collapse of Lehman Brothers. The key insight that stability can lead to instability plausibly captured the long post-Cold War experience and its shuddering denouement. 

By contrast, the equilibrium seeking system of modern macroeconomics, where such instability is impossible, was exposed as a flawed framework dangerously divorced from reality. In like fashion, the fallibility of the Efficient Markets Hypotheses was also exposed.

The shock of this realisation was famously expressed by legendary Federal Reserve Chairman, Alan Greenspan, who told a congressional committee in October 2008:

‘Yes, I’ve found a flaw (in my ideology). I don’t know how significant or permanent it is. But I’ve been very distressed by that fact. The modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year.’

The Rise of the Behaviouralists

The Nobel committee deciding on the 2002 award of the Memorial Prize in Economics chose to break with tradition by awarding the prize to a psychologist: Daniel Kahneman.

Primarily for his seminal paper with Amos Tversky in 1974 ‘Judgement under uncertainty: Heuristics and biases’, the award was an acknowledgement of how the work of Kahneman and Tversky had powerfully shaken the key assumptions underpinning modern macroeconomics and finance. Most particularly, the compelling portrayal of human decision-making as being littered with systematic short-cuts and biases casts great doubt over the key assumption of probability-weighted ‘rationality’.

More recently, a broad range of research in the area of behavioural economics and finance has further strengthened the argument that the market is not wholly efficient and can therefore be beaten. For example, in a speech to the London School of Economics ploughing a different, if related, furrow to Kahneman: ‘Herd Behaviour and Keeping up with the Joneses’, Andrew Oswald outlined the key insight of how individual rationality can often be consistent with collective catastrophe.

Taking his lead from the animal kingdom, Oswald argues that because human happiness is a function of relative rather than absolute position within a group, herding or clustering behaviour is the rational response of individuals to most situations. With a range of examples from fashion to frogs, he makes a powerful case that humans are frightened of falling behind and are consequently prompted to constantly adjust their relative position within a group just as an animal seeking safety will do likewise in a herd.

As with the herd however, this individually rational behaviour can on occasion lead to collective catastrophe. The stark image from Thomas Hardy of the flock of sheep plunging to their collective deaths, rationally following each other over the cliff to maintain their relative position, has clear implications for investors:

The Comfort of the Herd

Don’t Stop Believing

The trend toward passive investment is strong and not surprising. For those who believe that the market can’t be beaten, or even if it can that it’s prohibitively difficult to try, investing in passive strategies makes sense. By doing so however, they are eschewing the possibility of a significantly better outcome.

The evidence and rationale that the market can be beaten is compelling. If successful, the power of compounding makes the active approach significantly more rewarding. The search for a credible approach which gives a good probability of success is therefore worthwhile. Notwithstanding the current trend toward passive, the reports of the death of active investment are likely to prove greatly exaggerated.

Why try to beat the market? Because you can. Don’t stop believing.