Financial Theory rests on four pillars. The pillars are shaky, says Debashis Basu
The business schools reward difficult and complex behaviour more than simple behaviour, but simple behaviour is more effective. - Warren Buffett
When you pass out with a finance degree what are the most important ideas on markets and finance you get indoctrinated on? There are four key interconnected ideas that are supposed to form the theoretical bedrock of investment, portfolio management and financial planning. These are:
For any finance professional worth his or her salt these theories are holy tenets, in the absence of well-tested and well-developed investment science. Finance dominates everything but its theories have been primitive compared to other disciplines. So, finance schools have embraced anything that has the look of a robust theory -- so that it looks like they are teaching a solid body of knowledge. What do these theories stand for and are they really robust? Not quite. All four theories have too many exceptions making them, and whatever strategies are built on them, quite suspect.
Efficient Market Hypothesis was coined by Eugene Fama who theorised that all financial prices correctly reflect all public information at all times. In an article in Financial Analysts Journal in 1965 entitled "Random Walks in Stock Market Prices" he said: "In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value." This simply means that there is no mis-pricing and so you never under- or overpay for a stock given what is publicly known at all times. Prices may appear to be too high or too low at times, but it must be incorrect, only an illusion. According to Fama and followers, stock picking, market timing, or any other strategy that assumes that any investor is more knowledgeable than the market (which is the combined wisdom of all market players), is doomed to fail over the long term. If Fama is right, the entire brokerage industry and the entire fund management industry is built on shaky foundations at best and is a gigantic fraud on investors at worst. Under EMH, one investor cannot make more money than another with the same amount of invested funds since they will have the same information.
What is wrong with this theory? A lot. EMH does not recognise the many methods of analysing and valuing stocks. EMH does not recognise that some investors may be looking for undervalued market opportunities while others are looking for their growth potential. They will have different views on fair market value. Who is actually thinking "efficiently" in an efficient market? However, in real life everybody's returns are different. The assumption that there cannot be excess returns waiting to be picked has given rise to an interesting joke. One day, a professor of EMH and his student were taking a stroll. The student noticed a Rs 100 note lying around and pointed to the professor. The professor replied: it cannot be because the EMH theory says, it would have been picked up long ago. We know from real life that markets do not work efficiently. Very often speculative bubbles occur. Prices can remain overvalued or undervalued for prolonged periods even after information becomes widely available. But finance textbooks often convey a sense of orderly progression, markets that work with quiet efficiency without any disruption.
EMH says markets are efficient. Random Walk Theory says stock prices move in a random walk fashion. Price changes are unpredictable and occur only in response to genuinely new information, which by their nature are unpredictable. But if the markets were random and efficient, prices would cluster around the mean with very few occurrences at the edge (called outliers). But markets tend to have huge price swings that cannot be explained by randomness. For example, on May 17th 2004, the markets crashed so badly within the first few minutes of trading that trading had to be halted. The Sensex had fallen by 800 points or about 16% in a single day! On a random basis, this ought to happen once in a thousand years.
The combined effect of EMH and Random Walk is to suggest that no investor should ever be able to beat the average annual returns that all investors and funds are able to achieve collectively, which is represented by various market averages. From this theory has arisen the whole concept of passive investing: to put money in an index fund. Indeed, passive investing has been the average of active investing in the US over long periods. However, there are many examples of investors who have consistently beaten the market with completely distinctive styles - from Warren Buffett to George Soros to John Henry to Victor Sperandeo. The record of these men proves that markets are not random. There are not one but many different patterns in stock prices.
Modern Portfolio Theory developed in the 1960s with Harry Markowitz's work on portfolio construction, which he pioneered in his paper "Portfolio Selection," published in 1952 by the Journal of Finance. He made a remarkable discovery that would change investment theory and practice. MPT holds that the more diversified a portfolio, the less the risk from each of its components. It is one of the seminal ideas in finance. Some thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for a broad theory for portfolio selection. Before Markowitz's theory, investors focused on assessing the risks and rewards of individual securities. Markowitz brought in the idea of diversification, proposing that investors should select portfolios not individual securities.
He showed that risk is key to investment return and how investors can deal with uncertainty and risk by constructing a portfolio through asset allocation. All Dr Markowitz did was to mathematically prove the age-old adage:"Don't put all your eggs into one basket." The logic behind asset allocation is that different asset classes have different financial characteristics. Stocks, bonds, gold, real estate and cash all behave quite differently when it comes to risk and reward. For instance, stocks may offer the highest returns among various asset classes, but they also carry the highest risk of losses. The way to increase return is to seek a portfolio composition that optimises the risk and return.
Capital Asset Pricing Model Formulated and published by William Sharpe in 1964, CAPM decomposes a portfolio's risk into systematic and specific risk. Systematic risk is the risk of being exposed to the market. As the market moves, each individual asset is affected. Specific risk is the risk unique to an individual asset, uncorrelated with general market moves. According to CAPM, the marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away through MPT. When an investor holds the market portfolio, each individual asset in that portfolio entails specific risk, but through diversification, the investor's net exposure is just the systematic risk. Systematic risk is expressed as beta which is the variation of portfolio or asset vis-à-vis the market.
The reason why these four pillars fail to hold in practice is that investing is more of an art and less of a science. Investment decisions are made by human beings and are therefore prone to subjective judgement and human error. As long as we do not have a universally agreed system of pricing stocks, leaving room for subjective judgement, and as long as investments are made on the basis of hope, fear and greed, returns will vary from one person to another and the market will be highly inefficient. Three hundred years of irrational behaviour including Tulip mania, South Seas bubbles, real estate and gold rushes, concept stocks, dotcoms and Asian Crises have shown that investor psychology can move the market so violently that the four pillars of financial theory can come crashing down any time.
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