Extraordinary things have been invented by human beings throughout the centuries (e.g. electricity, the Internet). As part of our evolution, the notion of transaction has also developed, enabling many civilizations to expand wealth and build societies around the globe. Since the beginning of the last century, the speed at which information travels has been growing exponentially. Technological innovations have given us the opportunity to conduct transactions faster than ever and through more complex patterns (e.g. high frequency-trading, cryptocurrencies). Such evolutions in the ways of exchanging information have lead to something that is nowadays, in fact, quite known; it looks like “massive trading”, or more precisely, financial markets.
Do financial markets represent reality? In other words, are financial markets efficient1? The answer may sound obvious to some of us. Perhaps others would interpret it in a more sceptical way.
« One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute. » – William Feather
What does efficiency mean when talking about financial markets?
Here is the point.
An efficient market means that the prices observed are the right prices. Right prices should take into consideration all available information. For instance, when you see a stock price of $70 for Columbia Sportswear Co., it means that all the information about that company is quantified to give a price of $70 per share. The information that is available includes everything about what happened in the past, what is happening now, and what is expected to happen in the future. Thus, the concept of information is crucial when talking about financial markets. Needless to say, knowing more relevant information enables to find new opportunities.
And what if you could use information to make a profit?
« Style helps distinguish you… It’s a great potential opportunity that people tend to leave by the wayside » Michelle Obama. And what about making money with style?
Michelle Obama’s case shows perfectly how quickly the market reacts to new information. As the First Lady’s dresses were usually at the centre of public interest, many people wanted to buy the same because they were affordable and, of course, beautiful. In fact, studies2 have shown that the public listed companies from which Michelle’s dresses came were subject to unusual increases in their stock prices. The icing on the cake is that abnormal returns were appearing even before Michelle actually wore the dresses.
“Don’t lose good opportunities waiting for better opportunities” Mohit Bansal (unknown?)
How did the stock market react to unknown information?
Obviously, the information was not only known by Michelle. For example, “Michelle Obama is going to be dressed in a Calvin Klein gold ensemble this evening at the Democratic National Convention” was already known by a few, and the information spread into the market. Who could have been aware of that? Who could have acquired such a private information? In reality, someone in the White House, who was obviously looking through the keyhole of Michelle’s room, was providing the secret news. Unfortunately, some lucky investors, having a large network, could have gotten the news. Thus, they could have caught the opportunity to make a profit from it. In finance, fresh and relevant information provides opportunities to beat the market. Theoretically, you can only beat the markets if they are not efficient. In this particular case, few people were already beating the market by buying stocks from PVH Corp.3 before the First Lady was dressed.
“If I subscribed to the efficient market theory I would still be delivering papers.” Warren Buffett, American business magnate, investor, and philanthropist.
So, are markets inefficient? Can we prove it?
There exist a lot of empirical examples showing the inefficiency of markets. A great one is the 2008 financial crisis4. If prices could self-regulate themselves, then why did so many people lose all their money in the subprime crash? More precisely, were prices correctly evaluated before the crash? Were markets representing all the information available at that moment? In reality, the very large majority of people, even credit rating agencies, did not know how risky some financial assets were, as they emanated from complex manipulations (e.g. securitization, credit default swap). The subprime mortgage crisis is a typical example of situations in which the efficiency market assumption does not hold.
Perhaps, the financial system may have its limitations due to the fact that it is a purely human invention?