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The Fallacy of Efficient Markets and Why We Never Learn

The Fallacy of Efficient Markets and Why We Never Learn

28.11.2012 17:00

Everyone who has ever studied basic economic theory, mostly as part of a university curriculum, is somewhat familiar with the efficient market hypothesis or EMH. It asserts that financial markets are "informationally efficient" and, as a result, it is not possible for anyone to consistently achieve returns in excess of average market returns. In its weak form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. In the strong form EMH further asserts that prices instantly reflect even hidden or "insider" information.

Critics have blamed the belief in rational markets for much of the late-2000s financial crisis which we are still living through. For those who need reminding, the crisis flared up in 2008 in a way which threatened with total collapse of some of the largest financial institutions in the world, requiring the bailout by national governments of major banks previously thought of as infallible, and resulting in downturns in stock markets world-wide. The associated burst of several real-estate bubbles continues to affect population at large in countries as economically and demographically varied as US, Ireland and Spain. The crisis has played a significant role in the declines in consumer wealth estimated in trillions of US dollars, and lead to the 2008–2012 global recession and to the European sovereign-debt crisis.

Critics, ranging from market strategists to some high-ranking practitioners such as the former Federal Reserve chairman Paul Volcker point out that it was precisely the belief in the efficient-market hypothesis that caused global financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking".

So we have collectively acknowledged that our investment theory, our information systems and our understanding of the economic reality is incomplete or even outright flawed. Surely, we must have learnt how to modify our future behavior, too? We will not pile into investments that become hyped, will not engage in irrational speculation, will form own opinion and not follow trends which we don’t understand? Unfortunately, it appears that investor and decision maker behavior at large has not been showing any signs of correction.

What do I mean by that? In the many years that I have been working in corporate finance I have talked to decision makers in various corporations, who have been seeking to grow in international markets through acquisitions, to various private equity investors who carefully develop the investment thesis for their next global fund, and to a number of other, generally called, sophisticated investors, as well as many international investment bankers, lawyers, management consultants. Forget the efficient-market hypothesis. I have observed at first hand that most exhibit a herd mentality approach to resource and asset allocations.

In the early 2000’s technology was all the rage. Employees of large investment banks, usually brandishing dark suits and French cuffs, went for casual dress code over night, not just on Friday but every day. There were corporate emails in circulation in the largest Wall Street banks advising employees how to properly dress casually to fit with the tune of the day. Morgan Stanley (Morgan Stanley Dean Witter at that time), one of the leading brands among the global investment banks, changed the way they were calling themselves on documents and in promotional materials to “msdw.com”. A good friend of mine, Harvard and Chicago Law School educated, left his six-digit salary and a promising career with one of the leading management consultancies in New York to start an online wine merchant business. He was not alone in his absolute belief that this was the future. Many of us still remember the burst of that tech bubble, of course. This as an example of a sector hype. Have we learnt? Those who had been following the built up to Facebook IPO may find some disturbing similarities.

Now look at the geographical investment trends. When I first came to London in 1999, this was fresh in the wake of the Asian and Russian crisis, nobody would invest in Russia, do any business in Russia, or even go to Russia, the country was a total pariah. Investors left en masse, never to return again. In 2005, mere 6 years later, the same investment banks which couldn’t close their offices in Moscow fast enough, were poaching each other’s staff in Moscow by offering stratospheric sign-on bonuses because there was so much business potential, all these mighty IPOs and huge M&A deals, we just all had to be there. Why? Investors and bankers alike fully bought into the “BRIC” investment theme (I am still waiting for someone to explain what the four countries whose first letters form this acronym actually have in common, or, more precisely, why Russia is among them). In Russia, this has lived short of expectations. These days, bankers in Russia come much cheaper.

When you look at Central Europe, you can see the same over-simplification and herd mentality. These days, Poland is the country to invest in, whether you seek to buy shares, government bonds or a whole company. Why? Well, some people would tell you that it is a country with a large domestic market, the only country in the EU which escaped the recent bout of recession and is “still growing”. That of course ignores the fact that it is actually a mid-sized economy which is already slowing down. In terms of actual size, Poland’s economy is dwarfed by Germany, and when you translate the growth percentage into actual figures, the investment theme is not impressive any more. The long term competitiveness of Poland measured by investment in research & development or education is trailing even further down, while its industry is still awaiting wholesale modernization. Valuations are very high, inflated by the appetite of all the other foreign investors keen to “buy Poland” as well as the large Polish pension funds which are restricted in investing in foreign assets. So you cannot really buy assets in Poland at a good price. (Poland’s 2011 GDP was US$528bn, GDP growth 2.6% and, tellingly, R&D as percentage of GDP a mere 0.7%. This compares with US$3.48trillion, 0.6% growth and an impressive 2.8%, or US$97.4bn, of R&D as percentage of GDP, spent per annum in Germany). But most people don’t even engage in that kind of analysis. They rather continue to look for assets to buy in Poland on the principle “everyone does it I can’t be wrong”. You cannot really be blamed for doing what the others do. Whereas, if you are a contrarian and your bet doesn’t work out, the downside is large.

On a similar topic, I have recently had an interesting conversation with the CEO of one North American company. Otherwise well managed and highly profitable, a dynamic player in its core market, the company is evaluating the possibilities of overseas growth through acquisitions. The CEO was listening with great enthusiasm when I was describing to him the relative strengths of a certain potential target. The conversation, however, came to an abrupt end when I mentioned that the said company was based in Europe. “Oh no, thank you, I can’t invest in Europe these days”, was the end of it. It didn’t matter to him that the target company sources 80% of its materials outside of Europe, sells nearly 70% of its products in North America and has its entire business US$-based. He was not interested in the fine print, the actual facts. His board would simply tear him to shreds for investing in Europe because, as the US TV tells them, the Old Continent will soon come up in flames.
When will we learn?

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