The Efficient Markets Hypothesis in its semi-strong form says that the current market price of an asset incorporates all available information about the security in question. Coming from a family where my Mom was a successful investor, I had an impossible time swallowing the EMH, except perhaps as a limiting concept — i.e., the markets tend to be that way, but never get there fully.

I’m a value investor, and generally, over the past fourteen years, my value investing has enabled me to earn superior returns than the indexes. A large part of that is being willing to run a portfolio that differs significantly from the indexes. Now, not everyone can do that; in aggregate, we all earn the market return, less fees. The market is definitely efficient for all of us as a group. But how can you explain persistently clever subgroups?

Behavioral finance has been the leading challenger to the efficient markets hypothesis, but the academics reply that behavioral anomalies are not an integrated theory that can explain everything, like the EMH, and its offspring like mean variance analysis, the capital asset pricing model, and their cousins.

Though it is kind of a hodgepodge, the adaptive markets hypothesis offers an opportunity for behavioral finance to become an integrated theory. First, behavioral finance is a series of observations about how most investors systemically misinterpret investment data, allowing for value investors and momentum investors to make money, among others. The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it’s not worth the search costs any more.

Consider risk arbitrage strategies for a moment. Arbitrage strategies earned superior returns through 2001 or so, until a combination of deals falling through, and too much money chasing the space (powered by hedge fund of funds wanting smooth returns) made it less worthwhile to be a risk arb. It is like there were too many fishermen in that part of the investment ocean, and the fish were depleted. After years of poor returns money exited the space. Today with more deals to go around, and fewer players, risk arbitrage is attractive again. No good strategy is ever permanently out of favor; after a strategy is overplayed to where the prospects of the assets are overdiscounted, a period of underperformance ensues, and it gets exacerbated by money leaving the strategy. Eventually, enough money leaves the the strategy is attractive again, but market players are slow to react to that, becaue they have been burned recently.

Strategies go in and out of favor, competing for scarce above-market returns in much the same way that ordinary businesses try to achieve above market ROEs. Nothing works permanently in the short run, though as a friend of mine is prone to say, “There’s always a bull market somewhere.” Trouble is, it is often hard to find, so I stick with the one anomaly that usually works, the value anomaly, and augment it with sector rotation and the remainder of my eight rules.

Now, I’m not a funny guy, so my kids tell me, but I’ll try to end this piece with an illustration. Here goes:

Scene One — Efficient Markets Hypothesis

An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Nonsense. If there were a twenty dollar bill on the street, someone would have picked it up already.” They walk past, and a little kid walking behind them pockets the bill.
Scene Two — Adaptive Markets Hypothesis, Part 1
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. A little kid walking behind them runs in front of them, grabs the bill and pockets it.

Scene Three — Adaptive Markets Hypothesis, Part 2
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says quietly, “Tsst. Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. He grabs the bill and pockets it. The little kid doesn’t notice.
Scene Four — Adaptive Markets Hypothesis, Part 3
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He grabs the bill and pockets it. No one is the wiser.
Scene Five — Adaptive Markets Hypothesis, Part 4
An economics professor and a grad student are walking along the sidewalk, and the grad student is looking for a twenty dollar bill lying around. There aren’t any, but in the process of looking, he misses the point that the professor was trying to teach him. The professor makes a mental note to not take him on as a TA for the next semester. The little kid looks for the twenty dollar bill as well, but as he listens to the professor drone on decides not to take economics when he gets older.

This entry was posted on Monday, July 2nd, 2007 at 10:29 pm and is filed under Asset Allocation, Best Articles, Bonds, Industry Rotation, Macroeconomics, Portfolio Management, Stocks, Value Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.