Why the stock markets are not efficient 100% of the time
“I’d be a bum on the street with a tin cup if the markets were efficient.”
In both academic environment and investment world, there is this efficient market hypothesis which states those stock markets and any other prices on traded assets like bonds and property is also efficiently changes to reflect the true value of the assets. But there are a number of reasons why stock market is always inefficient and why it will remain so in future.
1. 90% of trades, buying and selling is done by institutional investors
These institutional investors include banks, insurance companies, pension funds, mutual funds and sovereign wealth funds.
Depending on the specific institutional investors, for example, actively manage mutual fund especially, as they need to achieve higher than market returns, and higher than other mutual funds returns in order to justify their high commissions and expense charges, they cannot simply buy and hold investment grade blue chips and then do nothing. In fact, by doing so, it will usually only achieve market returns.
As a result, they need to buy when market is going up and sell when market is going down so that annual returns will not look so bad when compared to other mutual funds company. As they controlled billions dollars of assets, a slight change in stock price means that it will either look very good on paper or look very bad.
In addition, when once in a century financial crisis occurs, ordinary small files need to cash out on their mutual fund holdings, but they cannot sell toxic assets because no one wants to buy, so they can only sell investment grades blue chips.
As you can see, this is one reason why stock market will never be efficient, at least some of the time.
2. Short term earnings are used to gauge value of assets, particularly stocks.
Unfortunately for both individuals and institutional investors, what the companies involved expect to earn in one year time, at most five years time, is used to gauge the value of the stocks and not what the businesses are going to earn throughout its lifetime.
The classic example to illustrate this is Warren Buffett purchase of Washington Post Company for $10 millions dollars in 1973 when Wall Street sells it at this price. Wall Street believes that this company will not achieve good earnings for the next year and their analysts are right, Washington Post Company really did badly for the next year but not for the next 30 years.
3. Not every investor is of the same breed
When stock market hits a new high, one can hear students and housewives dabbling in shares. But they most probably were willing to pay $10 millions for a company that is only worth $1 millions simply because they buy when they saw that the price is going up.
Experts in technical investing buy a few lots of shares for a different reason why people like Peter Lynch and Benjamin Graham buy the same shares. What technical investor sees as cheap, Peter Lynch and Benjamin Graham may see the same stock of that price as expensive, simply because based on some candlestick charts, the price is still low.
4. Fire sale of assets when something happen to the owners
If the only son of a billionaire with $1 billions of wealth is kidnapped and kidnappers demand a ransom of $500 millions, then he needs to fire sale his assets to raise money to redeem his son.
Fire sale of assets means cashing out assets like stocks and properties within a short period of time and get substantially less cash than what it is worth.
Or maybe some sovereign wealth fund loses billions by investing in western banks; it needs to sell off national assets to make it look good on paper to its citizens.
“As far as I am concerned, the stock market doesn’t exist. It is only there as a reference to see if anybody is offering to do anything foolish.”
Related posts:
