Brent Sheather: Markets behaving badly provide lesson

There is no overstating the extent of the losses investors have incurred from the economic crisis with some experts estimating that up to US$50 trillion of financial assets have been erased from collective balance sheets.

Locally everybody seems to know someone who has lost money on finance company debentures, CDOs, property schemes or the stockmarket.

But the crisis hasn't just affected portfolios, it has changed how people think and live. For example, in financial centres such as New York and London many previously sought-after jobs trading complex financial securities have disappeared and specialists in that area are out of work.

This has implications for universities as they must quickly react to the signals from the job market and start churning out fewer financiers and more engineers, which probably is no bad thing.

However, one of the biggest but less obvious losers from the financial crisis has been modern investment theory, specifically the widely held belief that investment markets are efficient - that is, they know what they are doing.

This theory, the efficient market hypothesis (EMH), was taken as gospel at universities in the 1970s and 1980s. But over time critics of its ability to explain reality have grown more vocal.

Examples of financial market irrationality over the past 10 years abound. In 1999 popular technology stocks were priced at 200 times their profits on account of forecast extraordinary profit growth; in early 2009 interest rates on short-term US government bonds went negative for a short while because the market feared depression or worse; and not so very long ago the world's biggest banks were lining up to make housing loans to people not only without jobs but also without houses.

Hindsight is a wonderful thing but the point is, could these widespread mispricings of assets have happened if financial markets were sensible? The clear implication of EMH is no, but happen they did.

A couple of weeks ago in London, Professor Andrew Lo of the Massachusetts University of Technology, spoke at a conference of investment professionals on just this subject. Lo has been good enough to provide Herald readers with the background papers to that lecture.

But first a bit more about the EMH: it's easiest to explain by way of an analogy. An economist walking down the street with a friend sees a $100 note on the ground. The friend bends down to pick it up, but the economist says, "Don't bother, if it was a genuine $100 bill someone would have already picked it up."

This is the key assumption of the EMH - that a share price already fully reflects all public and private information known about it, thus there are no bargains lying around on the NZX, ASX or NYSE for clever analysts to take advantage of.

At the time this made a lot of sense, and still does sound sensible, because there are lots of people researching stocks so the overall effect of all their efforts must be to make prices reflect reality. But that's clearly not the full story. Lo's work questions how efficient things are and suggests that efficiency comes and goes.

EMH was, up until recently, the only game in town and I, too, relied on it to give stockbroking advice in the 1980s and 1990s. I would routinely tell people wanting to buy low-priced shares that they were at that price because they were going bust (that is, the $100 bill is a fake).

Most times that strategy worked well. But there were some embarrassing exceptions - that is, some of the $100 bills were real. A few of the stocks that got down to 5c to 20c did recover and gave their owners returns of 20 times or 30 times their purchase price - for example, Corporate Investments, which turned into Montana Wines and Baycorp.

Lo's paper begins by documenting some well known examples of irrational behaviour by investors including overconfidence, overreaction, loss-aversion, herding and regret. Critics of the EMH argue that investors are almost always irrational and exhibit these predictable and financially ruinous behaviours.

Lo suggests that back in the 1970s economists tried to legitimise their work by attempting to find the same sort of overarching themes that explain the physical sciences, such as physics, for economics. Lo calls this "physics envy" and argues that physical systems are much simpler than economic systems so this sort of logic doesn't work in economics.

Instead, he proposes what he calls the Adaptive Markets Hypothesis (AMH), which argues that market efficiency comes and goes depending on environmental conditions and the number and ascendency of "species" in the market. By species he means market participants such as pension funds, retail investors, hedge funds, etc.

An example will help in understanding this: in the cheap credit environment of 2007, interest rates on risky bonds were forced to a particularly low level because hedge funds and CDOs were dominant, outpricing alternatives such as pension funds.

Today hedge funds are on the back foot and credit is not so readily available so, with this major buyer out of the market, interest rates on risky bonds will be much higher.

So what do inefficient markets mean for retail investors? One of the key implications of the EMH is the attractiveness of passive funds. If markets are truly inefficient active fund managers should routinely be able to beat the market. But in the past 12 months the evidence, according to the London Financial Times, has been that, despite a falling market, which provides the most favourable background for an active manager, active managers have not outperformed.

In fact major institutional investors have recently been reported as shifting more funds from active to passive management.

How can we reconcile this with the death of EMH? The answer probably is that, although markets are inefficient, the reason they are inefficient is because active managers are subject to the same behavioural nuances that affect the performance of the market as a whole.

So while the market is not perfect at setting prices, this doesn't make the job of beating the market that much easier. But not everyone exhibits these behavioural traits. There seem to be a few special people around like, perhaps, Warren Buffett who can consistently beat the market. Lo's AMH says that because market dynamics change, the success of specific investment strategies adopted by individual managers will come and go.

The solution for retail investors is likely to be a mix of passive and active funds while keeping foremost in your mind that your own decisions are likely to be vulnerable to the behavioural traits outlined earlier.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.