By Abhishek Gaurav

Edited by Shambhavi Singh

wall-street-bullFinancial Markets are highly competitive. Thousands of market researchers and analysts are in the constant lookout for under-priced securities which can be invested in to generate profitable returns. A prominent school of thought in Economics led by free market thinkers as Eugene Fama, Paul Samuelson and others believes that this endless competition would undercut any existing arbitrage opportunity in the markets leading to what is known as the “no-free-lunch proposition”. It is not possible to generate riskless profits in the markets. Ceteris paribus, investors would prefer such investment opportunities that provide the highest expected return.

But higher investment return entails taking on higher investment risks. If higher returns could have been made without taking on extra risks then there would be a rush to buy such assets. Increasing demand of such assets would drive up their prices ultimately decreasing the returns made on them. This concept of risk-return trade-off features very prominently in the financial markets.

The foundations of efficient market hypothesis were laid down by a French mathematician Louis Bachelier in 1900 in his PhD thesis titledThe Theory of Speculation”. His work involved stochastic modelling of financial data to resolve the central paradox in financial theory that is “if the markets are random, then how do people make money?” His theoretical formulations, though they remained largely unnoticed in the early 1900s, caught the attention of subsequent market researchers. Alfred Crowles in his 1932 paper “Can Stock Market Forecasters forecast” concluded that during the period from January 1, 1928 till January 1, 1932, the financial services firms on an average performed worse than the portfolio of common representative stocks. This gave further weight to the notion that it is not possible to consistently outperform the markets. Maurice G. Kendall and A. Bradford Hill in their 1953 paper titled “The Analysis of Economic Time Series- Part 1: Prices” found that the stock prices exhibited no predictable pattern.

“The Analysis of Economic Time Series- Part 1: Prices” found that the stock prices exhibited no predictable pattern

Prices evolved randomly, regardless of their past performances. The result came as a surprise to many financial economists of the times who felt that this is a pointer to the irrationality of markets which behave in an erratic manner. However, the later independent works of Eugene Fama and Paul Samuelson in the late 1950s explained the reasoning behind this spectacular result that it is the competition among intelligent traders and analysts which inevitably leads to random walk behaviour and market efficiency.

If prices are determined rationally, then they would adjust only to new information. Therefore, a random walk essentially implies that prices reflect all the current knowledge. Indeed, if stock price movements were predictable, that would be a glaring evidence of stock market inefficiency, because the ability to predict prices would indicate that all available information was not already reflected in stock prices. But this again leads us to the central issue of why should stock prices reflect all available information? After all, if investors and traders spend their valuable time and money on gathering, uncovering and analysing information, that they believe has been overlooked by the rest of the investment community, they would expect profitable returns from it.

If stock price movements were predictable, that would be a glaring evidence of stock market inefficiency, because the ability to predict prices would indicate that all available information was not already reflected in stock prices
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In this context, Grossman and Stiglitz have talked about the concept of varying degrees of efficiency across markets arguing that small stocks which receive relatively little coverage by Wall Street analysts may be less efficiently priced than large ones. Thus, although there is a consensus among the economists that the prices may not uncover all the information all the time, still, competition among various well-backed, intelligent analysts should ensure that as a general rule, stock prices reflect the available information and attempts to outperform the markets do not consistently bear fruits, thereby, advocating  a passive investment strategy. Empirical studies indicate that the doctrine of efficien markets, though is paralysed with several anomalies, is able to explain the stock price movements over long durations of time and therefore, any supposedly superior investment strategy should be taken with a pinch of salt. There is enough competition in the market that only differentially superior information or analysis would fetch positive returns; and so as we stated earlier, there is no free lunch.

Abhishek Gaurav is a B.S. – M.S. dual degree student in Economics at IIT Kanpur. He has a prior experience with the development economics centric research arm of MIT, Abdul Latif Jameel Poverty Action Lab (J-PAL), primarily working in the area of evidence based policies. His interests lie at the intersection of economics, politics, policy and finance.

Posted by The Indian Economist | For the Curious Mind