Full Disclosure Finance

By Justin

As I was flying out to Nova Scotia last week I picked up a copy of Condé Nast: Portfolio from the infamous Air Canada Maple Leaf Lounges (best part of traveling by far). An article entitled “The Evolution of an Investor” was the feature. The skinny is a successful Wall Street type retained his conscience a little longer than most in the industry and he details The Big Investment Firm’s emphasis on client’s fees, not the returns their advice delivers. The article is worth a full read because of the high level of detail and analysis of efficient market theory as it pertained to his investment career.

After the meaty details of the investor’s life, focus shifts toward his decision to join Dimensional Fund Advisors (DFA). DFA is touted in the article as the only available alternative to the current Wall Street money grabbers that under perform the market year over year.

The article is seeded with “Just give up on trying to beat the market and hand your money over”, which sounds like most people selling index funds. Well, I was right. DFA denounces all investors that consistently beat the market. “If millions of monkeys throw a bunch of darts at the Wall Street Journal, at least one monkey would pick a winning group of stocks.” This is where my interest level rose higher than Amy Winehouse on Vancouver’s East Side.

“Investors who try and pick stocks or time markets are fools” is followed up by “You can tell a story every day about stocks”, “that’s what the media are all about. They tell a story every day about today’s stock returns. It’s businessman’s pornography” Boo-ya CNBC!

A Random Walk Down Wall Street is touted as a necessary read for outlining the efficient market hypothesis. How does this affect us? If we follow word for word, we clearly must give up entirely and close our (Prp) Trade King accounts. We should then hand our money over to DFA or buy any ETF. Then go on with your life and count the money when you’re 65!

Alright, we have quite the battle brewing between the upstart efficient market promoters (DFA and academia) and the conventional “the market is inefficient, there is value everywhere, so read every business magazine and trade 100 times a quarter” Wall Street / Bay Street crowd.

How do we handle this? Well I think we should educate ourselves about both sides of the issue to start.

So efficient market theory, what does it mean for an amateur investor? Well, let us look to the great Investopedia for an answer. After typing in “Efficient Market Theory” responses like Thin Market and Vertical Market are provided, no Efficient Market Theory anywhere. I guess we know where Investopedia stands on this issue. Looking elsewhere, there are 3 forms of the hypothesis:

1) Weak form: All past price behaviour and data is already reflected in the present price of a stock. Therefore using technical analysis to identify patterns and predict future activity is not possible.
2) Semi-strong form: All information available to the public is reflected in the current stock price. Therefore, it is not possible to have a stock that is under or over valued by the market.
3) Strong form: All information, public and insider, is reflected in the stock price. Therefore, it is not possible to use insider information to an individual’s advantage in the market.

A key point regarding the validity of these hypotheses lies in the necessity of the market’s participants to assume the market is inefficient. Participants must trade with the intention of beating the market, or else we would all be passive investors.

Passive investors do not analyze securities and therefore would not buy or sell based on new information. Therefore, stocks would not immediately reflect all available information as indicated in the Strong form if we were all passive. There would be a delay in any price changes until we got off the couch, read our email, and bought or sold accordingly.

Inefficient market theorists are pretty much everywhere. Any business channel or magazine will always be analyzing the “newest, best” value stocks and recommending them. Jim Kramer and Mad Money are the examples that come to mind first. His recommendations from December 21, 2007 are as follows:

Buy:
Apple Computer Inc (AAPL)
Agrium Inc (AGU)
Bunge Ltd (BG)
Deere and Co (DE)
Freeport-McMoRan Copper & Gold Inc. (FCX)
First Solar Inc (FSLR)
Gamestop Corp (GME)
Intercontinental Exchange (ICE)
Johnson Controls Inc (JCI)
Jacobs Engineering Group Inc (JEC)
Lundin Mining Corp (LMC)
Landec Corp (LNDC)
LSB Industries Inc (LXU)
Monsanto Co (MON)
Occidental Petroleum Corp (OXY)
MEMC Electronic Materials Inc (WFR)
Horsehead Holding Corp (ZINC)
Sell:
ingli Green Energy Holding Co (YGE)

So where are we now? Are you confused or have you been intrigued enough to read more deeply into efficient market theory? We could use the best of both approaches and begin rating markets according to their efficiency on a scale from 0 (totally passive) to 100 (totally efficient). This would actually be very useful and serve to improve efficiency in some markets. For example, in Country A, their highly efficient financial system is rated a 95. In country B, however, they have a rating of 85. Someone looking to be an active investor (Mr. Active) would then move toward Country B because his analysis work could potentially generate greater returns. More reward potential would exist because there would be fewer investors acting immediately on new information. By the time Mr. Half Active gets into the game based on the “new” information, our wise Mr. Active is already in.

If a large number of Mr. Actives moved to Country B to exploit this variance in efficiency, there would be less Mr. Actives in Country A.
This would in turn increase the rating of Country B and decrease the rating of Country A and in turn act to moderate efficiencies across various countries.

This would encourage acceptance of Efficient Market Theory as a useful tool for evaluating a market.

Overall, if you consider that efficient markets rely on its participants behaving as if it is inefficient, it does recognize that the current market is unlikely to change significantly in light of the theory. Large investment firms aren’t going to fold up because their managers can’t beat the market, they’re not even concerned with customer’s returns in the first place. It is in their best interest to increase the public’s level of interest in the market so they will participate and generate more fees.

I think there is room for improvement in the industry. Increasing transparency in business magazines would be helpful. How about a magazine stepping up and requiring all contributors to post their own annual rates of return for the last 10 years. Then we’d really see the results of the “Wall Street Journal Dart Championships”.

What does this really change?  I’m not quite sure, but in the interest of continually increasing my financial education, A Random Walk Down Wall Street will be in my hands soon.