Home Business Efficient Market Theory Disproven – The Nail in the Coffin

Efficient Market Theory Disproven – The Nail in the Coffin

Efficient Market Theory Disproven - The Nail in the Coffin

In the world of finance, there are a few different ways you can analyze markets and stocks. You have your basic fundamental analysis, which relies on  financial reports, ratios, earnings, etc. Technical analysis is interested in the charts and the trends that lie within the charts. You have the more advanced quantitative analysis, which uses complex algorithms to determine price actions. What is value investing? Value investing is the process of investing in companies that have been unfairly beaten down or cheap for some reason, yet the underlying business story is still intact. It’s safe to say that value investing uses fundamental analysis primarily.

Value investing has been around since 1934, when the famous Benjamin Graham and David Dodd wrote Security Analysis. Graham and Dodd were both professors at Columbia Business School, which could be why the school has been in full support of value investing and fundamental analysis.

Academia has since developed a more different definition of the world value. To them, value is more about stocks with a low price/book which means that the stock is cheap based on book value. This strategy has often outperformed other strategies in the last few years.  In this case, a growth stock would have a high price/book because investors are paying for growth.

The interesting thing that most people do not understand is that value can provide higher returns than growth. Value is often seen to be slow, conservative and borrowing.

Professor Tano Santos,  of Columbia Business School, did research on a very interesting topic. He took ten portfolios, which ranged from extreme growth to extreme value. What they found was that the extreme value portfolio annualized returns of 10.9% compared to extreme growth’s 3.8%.

This means that deeply discounted stocks tend to outperform the  growth stocks that most traders and investors go after. The interesting part is, if extreme value outperforms extreme growth over 7% annualized, why are traders and investors so focused on growth stocks over value?

This should not be news to value investors. But there is big news below. When the proponents of the efficient market theory, finally discovered that value truly does beat growth, they had to uphold their theory somehow. They claimed that value beats growth because value stocks are riskier. On a risk adjusted basis, value stocks under-perform growth stocks.

A little bit about the theory: the efficient market theory says that that investors/traders act on all relevant information as soon as it is made available. This means that stocks are priced to the expectations of the investors that are in those stocks.

How have academics defined risk?  I quoted Santos below:

The canonical model of risk in finance is the Capital Asset Pricing Model (CAPM). According to the CAPM, beta, the extent to which the returns of a particular security co-vary with the return of the market portfolio, should be the only source of variation in average returns across securities. Thus, if the CAPM is the right model of risk, then it has to be the case that the value premium is only attributable to differences in the betas. Well then, does the extreme value portfolio have a higher beta than the extreme growth portfolio? The answer is no.

This is the nail in the coffin to the efficient market theory. Value stocks beat growth stocks even on a risk adjusted basis, at least risk as defined by CAPM.  We have no doubt, that as these ideas are figured out by more academics, they will change their definition of risk. It is very difficult to admit being wrong after all.

However, for now the efficient market theory has been buried by Tano Santos. It is worth studying the theories to understand the theory, just like disproven scientific theories are worthy of study. However, no one should think that the theory has an validity.

See the chart below from the study, which provides some interesting insights: