The joys of inefficiency

I think every single stock investor in the world instinctively disbelieves the Efficient Market Hypothesis. That's why we're investors, aren't we? I mean, the whole point of investing in stocks is to make more money than X, where X could be your irritating colleague, your brother-in-law, or the markets in general. Investing in stocks is, by its very nature, a quest to do better by using your brains.

Unfortunately, the fact that we want to believe something doesn't make it true. The hard fact is that the EMH has collected a great deal of hard proof of its correctness over the last 60 years. In the US markets, the biggest proof of the EMH is the failure of a vast majority of mutual funds and hedge funds to beat the broad market indices. This is generally taken as contributory and circumstantial evidence, which shows that it's not possible to beat the markets. Of course, it may actually be proof of something completely different. It could, for example, be proof of the fact that the US fund management industry is structured in such a way that most fund managers are incompetent. The way I see it, the poor performance of American fund managers is a separate issue entirely.

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Is the converse true? If the poor performance of fund managers is neither proof nor disproof that EMH does or doesn't work, then would good performance of fund managers mean that EMH doesn't work and that it's possible to beat the market? I think so. The EMH is relevant to a certain stage of development and maturity of a country's businesses and stock markets.

At the heart of the EMH is the idea that any piece of information that is known to the market generally cannot be used to derive an advantage. That's crucial. I think the awareness and absorption of information flow in a rapidly changing market like India is inherently different from the US. The pace of change in the Indian economy is very high. Sectors, companies, and business advantages can be transformed in a few years and sometimes in months. In such a scenario, even if a piece of information is known to all in theory, an understanding and appreciation of its relevance cannot be said to be universal.

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The flood of fundamentally important information is so high that even if the news is 'out there', it may be useful to some and not to others. In such a situation, it's easy for some investors and investment managers to be consistently ahead of the curve and beat the markets. Does the EMH not apply to all markets? No, it doesn't, and even Nobel laureate Eugene Fama, the one who introduced the theory to the world, doesn't think so unequivocally. In the accompanying interview, when asked 'Are all stock markets equally efficient?', he says, “In emerging markets, well, I think maybe insiders have more information than they do in domestic markets, but maybe not. In any case, there's not enough data to know about emerging markets. And the variances are so big that it would be impossible to know anyway. When people study money managers in developed markets, they don't find any evidence that those markets are inefficient … and there's very little evidence that they're inefficient in the United States. But I've never taken the extreme position that markets are entirely efficient.”

As the institutionalised 'global' style of investing makes deeper inroads into India, there's an increased reliance on processes and theories. These have a role, but I firmly believe that individuals matter, and the skills and instincts of the individual play a deep role in investment success.

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