3: Efficient Market Hypothesis

• The efficient market hypothesis is a theoretical benchmark discussing market price reflections and market participant expectations.
• It serves as a helpful discussion tool, but remains a theory that may or may not be accurate.

Definitions of Market Efficiency

• Definition A: A market incorporates all available information into the market price at any time.
• Definition B: A market makes it impossible to gain economic profits via trading on information set.
• Economic profits constitutes risk-adjusted returns net of all costs in definition B

Forms of Market Efficiency

• Weak-form: All historical information is already included in the market price.
• Semistrong-form: Public information is immediately incorporated into the market price upon release.
• Strong-form: All possible information, including insider information, is included in the market price.

Implications of Strong-Form Efficiency

• If the strong-form is correct, then no one can have an information advantage.
• Consistently profitable active trading is never possible if the strong-form efficiency holds true.

Arguments Against EMH: Stock Picking (Lawrence, 2013)

• Individual buy-and-hold investors benefit from clear and concise financial statements.
• Firms that possess more readable statements have stronger inflows, leading to increased investor returns.
• If EMH is followed, readability should not matter; all information is already incorporated.

Arguments Against EMH: Market Timing (Dahlquist et al., 2017)

• The study uses specific setup data from a particular Swedish fund.
• Findings on overall profitability are not representative of the wider market.
• Active traders can increase returns through timing funds and asset classes via EMH.
• It is not a clear, general argument against the EMH

Evidence against EMH: Momentum (Jegadeesh and Titman, 1993)

• Recent performance of stocks predicts short-term future performance.
• Winning stocks continue to win, and losing stocks continue to lose.

Methods and Models In Finance

• Despite EMH, some well-published articles suggest strategies exist for active trading.
• Many methods in finance guide active strategies: Capital Asset Pricing Model, Chart Analyses, and other prediction methods.

Active Trading

• Investing more or less in company shares than implied by market capitalization indicates an active strategy.
• Employing an active strategy means quantitatively adjusting shares or entirely including/excluding positions.
• The "market portfolio" concept, where MVi = (Number of Shares of i) × (Price per Share of i), with the allocation to each company (xi) determined by its proportion of the total market value.

Active Portfolio

• S&P 500: 500 largest US-listed companies
• Russell 2000: 2000 smallest of the 3000 largest US-listed
• NASDAQ-100: 100 largest non-financial US-Nasdaq-listed companies
• Nikkei 225: 225 largest Japan-listed companies
• MSCI World: all large- and mid-cap companies from 23 developed markets
• MSCI Emerging Markets: all large- and mid-cap companies from 24 emerging markets

Examples of Stock Picking

• In 2023 within the S&P 500, if an investor picked only the companies that were winners, they would have gotten higher returns, and not invested in companies like Pfizer, whose share price fell 44%.
• Nvidia's share price rose 239%.
• For comparison, S&P 500 rose 24.2%

Active vs Passive investing

• Passive investment invests indiscriminately, and an active trading strategy tries to pick better or worse times effectively.
• Active trading stock picking and timing possess benefits that are potentially substantial.

Contrasting Investors

• Passive investors do not compete with each other and ensure average returns.
• Active investors or value investors benchmark against market portfolio returns.

Active investing

• Active investing is a zero-sum game in which one active investor's profit is another's loss.
• Achieve average returns exceeding the market requires consistent outperforming active investors.

Understanding Market Valuation

• Market valuation considers value-relevant events and expectations, even when uncertain.
• Successful active trading needs relevant information traded upon before the market does.
• Timing requires anticipation of movements just before they happen.
• Stock picking indicates distinguishing winners and losers before the market price reflects data.

Evidence Against Active Trading

• Barber and Odean (2000) showed the more stock traders trade, the lower their net returns.
• No group in the study was able to beat the market.
• The initial U.S. evidence has been replicated in Taiwan (Barber et al., 2008), Germany (Koestner et al., 2017), and Canada (Linnainmaa et al., 2021).
• Barber et al. (2020) showed that 74% of day traders have a history of losses.

Contract-For-Difference Trading

• CFD technically classify as derivates and derive value from other assets.
• CFDs involve purchasing the right assets at specified prices, effectively betting on future prices.
• Seen as active trading, which could be market timing.

Regulations surrounding Trading Platforms

• Poor performance results in regulators legally requiring platforms to state the amount of money that is lost
• The vast majority of investors lose their money.
• All of the evidence relates to private individuals, but not professional traders.
• Mutual fund companies consist of actively managed funds which intend to outperform that market while being very large.

Mutual Funds

• Malkiel's 2003 study determined the majority or mutual funds underperform and samples appear positively biased.
• Although funds add value, the median destroys value (Berk and DeMarzo, 2019).
• Private investors do not benefit.

The Long-Term Capital Management Anecdote

• Long-term fund was founded in 1994
• It had $4.7B equity capitalization in 1998
• It was Headed by John Meriwether, Myron Scholes, and Robert C. Merton
• It experienced bankruptcy in 1998.

Efficient Market Hypothesis: Summary

• Some evidence suggests profiting from an information is available
• Historical evidence is unencouraging
• Active trading or high-activity funds cannot be recommended for private wealth creation

Examples of excluded approaches

• Exclusion simplifies the debate and judges asset classes from a wealth-creation perspective.
• It applies to asset classes not recommended for wealth creation.

Considerations in Growth Investing

• The acceptance to avoid a trend profit from short-term ups and downs
• Surfing growth invests in the long-term upward trend
• Growth-investing is only applicable if there is a surf trend.

Forex Market

• Consists of trading currencies against foreign exchange-markets
• The currency exchange rate fluctuates, which opens the door towards active trading.
• Long-term trends are not generally visible, and can be small.
• Profiting from short-term trading is categorically not possible and long-term growth trading is not very interesting.

Investing in Gold

• Involves investing in commodities (such as oil, electricity, etc)
• Gold price is only marginally higher, and does not cover inflation, savings provides higher returns
• Is an addition to the portfolio because it goes up in times of crisis, but this reasoning is highly skeptically.
• Sizable propotion to have a sizeable effect, our general approach as growth traders is not neutralizing crises, but weathering them. Historical data suggest that a long enough investment horizon is all the insurance we need.

Other excluded approaches

• CfD trading
• Options
• Cryptocurrency