Clear Thinking on the Causes of Financial Market Inefficiency

This article was first published on my LinkedIn page in March 2018

Almost every finance and economics graduate student is taught the Efficient Market Hypothesis (EMH); this theory states that the prices of financial assets reflect all available information, which leads to 'efficient' pricing of those assets.

This means that market participants can determine the prices of financial assets in a way that allows it to reflect its true risk and return characteristics. However, people should not be fooled by such a notion because inefficiencies are inherent within financial markets.

The two overarching themes that lead to inefficient asset prices are:1) institutional, and 2) psychological.

Financial market-related institutions are organized in a way that creates conflicts of interest that results in mispriced securities. Psychological factors also contribute to asset prices. Behavioral finance studies the many cognitive biases that come into play within the financial markets, which undermines a key EMH assumption that all market participants are ‘rational’.

The combination of these two overarching themes (institutional and psychological forces) will at times result in a mismatch between the intrinsic value of a financial asset, and the price at which the security is sold.

A solid understanding of these factors may help market participants achieve a better financial future.

The intrinsic value of a financial asset (or security) is determined by estimating the present value of expected cash flows that the security can produce over its lifetime. This involves estimating two variables:

1) the future cash flows of the asset, and

2) the appropriate discount rate at which those cash flows are to be discounted to account for the time value of money*.

During times of tranquility, market prices tend to be reasonable. During times of turbulence, institutional pressures coupled with ‘animal spirits’ allow for inflated asset prices, whereas during times of panic, the opposite is true.

Weighing the psychological and organizational influences on the underlying variables that dictates asset prices (cash flows and discount rates) can help investors make better decisions.

The psychological component of financial market behavior is so powerful that, during extreme times, many market participants will ignore those variables that determine the price of a security - often because of the irrational belief that the asset will keep going up (or down) quickly, linearly and indefinitely.

A Random Walk Down Wall Street: Dissecting the Theory

The Random Walk Theory suggests that the movement of stocks takes a random and unpredictable path, and that it is impossible to achieve higher returns without assuming additional risk.

The EMH, which suggests that all security prices are ‘efficient’ also suggests that a security’s price reflects its risk-adjusted returns; the implications thereof is that it is impossible to outperform (and by that same logic, underperform) the market average over a sufficiently long period.

The EMH takes on three different forms, but the main two forms that I will focus on critiquing are the semi-strong and strong forms of EMH. The semi-strong form EMH states that asset prices fully reflect all public information, and the strong form EMH states that prices reflect all information, including ‘inside’ information.

This notion suggests that the prices of securities will reflect its intrinsic value at all times. Under the EMH, all investors can achieve the appropriate level of risk-adjusted return, and prolonged under or over performance by an investor can be explained by the theory as statistical outliers.

Why do academics believe in theories that seem impractical? And how do we go about disproving the theory?

The EMH is harder to disprove because, although it is not practical for real-world application, it is a theory that is logically valid.

Let me explain.

Logical validity is a result of internal consistency; an argument can be logically valid as long as the premises set forth are consistent with the conclusion. An argument with a false premise can be logically valid yet untrue.

There are three particular premises that the EMH is built on, which must be identified and falsified in order for it to be disproved.

The first critical assumption is the availability of perfect information, which all ‘rational’ market participants can effectively assimilate.

Another default assumption used by academics is that all market participants are rational individuals who act in their own self-interest. This notion entails that people will respond in the most effective manner to situations, and do not make random, impulsive, and uncalculated decisions.

The reason why the EMH does not take these institutional and psychological factors into consideration is largely because academics formulate economic models by trying to simplify, eliminate or minimize the number of variables.

These models hold external variables constant in order to improve the model’s precision as economists want to quantify everything- which is impractical when dealing with the psychology of the masses. This focus on precise answers substitutes accuracy for exactness.

If you hear an economist say ‘ceteris paribus,’ which is Latin for ‘all other things remain equal,’ it means the model was formulated in a vacuum.

Institutional Considerations: Financial Market Gatekeepers

1. Be Wary of your Analyst

The institutional reasons that cause inefficient market prices results from misaligned incentives and conflicts of interests that are prevalent in financial market-related companies.

These companies are mainly the ones that issue and underwrite the securities of a company, and the firms that audit them. Many investors get their financial information from people who they consider experts; these people are usually analysts who work for investment banks, and people from the media.

The problem of taking advice from an analyst is that he gets his (very large) paycheck from the firm he works for, which is more likely than not an investment bank, and not from you, the investor.

Conflicts of interests arise because of how investment banks are structured. Traditionally, investment banks have three primary sources of income: corporate financing and advisory (which is the function responsible for issuing securities), brokerage services, and asset management. The relationship between the corporate finance division and the brokerage services division is where a large part of the conflicts of interest arise, which results in mispriced securities.

The analyst, who works for the investment bank’s brokerage division, is expected to establish and maintain a good relationship with the management of the companies he covers so that he can bring in more business to his investment firm’s corporate finance division.

Whenever a company that is being covered by a particular investment bank’s analyst needs to issue securities, or engage in a merger or acquisition, the corporate finance division can count on that analyst to bring them on as a client.

This means that the relationship the analysts have with the companies they cover can result in more business for the other divisions of the investment bank, which leads to a larger paycheck for the analysts themselves.

How does this disprove the EMH, you may ask? In order for analysts to maintain good relationships with the companies they cover, they often predict an optimistic future for their clients in the reports they issue by assigning the companies higher growth estimates.

This becomes a more significant problem when an investment bank has already helped a company with some of its financing needs in the past. In a July 14, 1992 issue, the Wall Street Journal released parts of a Morgan Stanley internal memo that revealed the nature of this conflict of interest. The memo read, “Our objective...is to adopt a policy, fully understood by the entire firm, including the Research Department, that we do not make negative or controversial comments about our clients as a matter of sound business practice.”

The conflict of interest problem becomes more substantial when you consider that many securities analysts can form symbiotic relationships with the management of the companies they cover.

As a result, the analyst’s life becomes much easier as he receives company perks, hints and tips on the performance of the company. Moreover, some analysts are often influential amongst institutional investors, which means their optimistic outlook on companies can generate large trading commissions for the brokerage division for which the analyst works.

It would be tough for an analyst to give a ‘sell’ recommendation to a company that it recently underwrote or recommended; it destroys relationships, and it is bad for business. There is vast literature available that demonstrates the points I make: according to one study, buy recommendations (those made by analysts who work for investment houses that also have underwriting relationships with the company they are analyzing) have underperformed all other buy recommendations.

In another study, the average consensus 12-month earnings per share growth forecast were 17.7%, which was more than twice the actual growth rate. In short, analysts provide their biased research to investors who then overpay for these stocks, which should not happen according to the EMH.

2. Be Wary of your Auditor

A company’s management and its auditors are incentivized to paint a rosier financial picture for the company. It is the auditor’s responsibility to detect and warn against any material deficiencies in a company’s reporting or internal controls.

A public company’s management will sometimes use legal, but liberal, accounting rules to prop up the price of the company’s stock, which is tied to their compensation package.

On rare occasions, a company’s management may use less than legal accounting techniques to prop up the value of its stock. This is where investors, creditors, and regulators depend on the auditor’s report.

When an investor looks through the annual reports of a company, they may begin by looking at the auditor’s opinion to make sure the information provided is sound and does not contain material errors. Most auditors issue truthful, clean opinions, but occasions do arise when auditors give clean opinions to companies that don’t deserve it.

Consider how in 1985 the big eight (now the big four) accounting firms were obligated to pay $180 million in settlements for audit-related lawsuits. More recently, these cases have gotten worse. The New York Attorney General filed lawsuits against Ernst & Young for allowing Lehman Brothers, a now- defunct investment bank, to move $50 billion of assets off their balance sheets using an accounting tactic called Repo 105. In 2013, Ernst & Young made an initial agreement to pay $99 million to settle with Lehman bondholders.

PwC, an auditor, paid $225 million to settle a lawsuit with Tyco International shareholders due to a “breakdown in the audit function”. Deloitte, another auditor, had a $275 million lawsuit brought against it for offering misleading opinions about Bear Stearns, which is an investment bank that was acquired by JPMorgan as it was on the brink of bankruptcy.

Clearly, the auditor’s opinion should be taken with a grain of salt.

Advocates of the EMH argue that the prices of securities reflect all available information, leading to efficiently priced financial assets. But this argument is based on the assumption that all market participants are equally rational and capable of effectively assimilating information.

If this were the case, then certain investors wouldn’t have been able to profit from the collapse of particular companies that, with the help of auditors, tried to hide their financial woes. Two good examples of such investors include David Einhorn, who profited from the demise of Lehman Brothers, and Jim Chanos, who raised concerns about Enron, before its bankruptcy, which was the largest at the time.

The reason as to why auditors sometimes ‘turn a blind eye’ to misreported financial statements is twofold.

The first problem arises because the auditors’ client, or the company being audited, is the one who pays for the audit fee. Consider the fact that large corporations can pay between $3 million to above $60 million in audit fees; the auditor is incentivized to keep the client happy, otherwise, the client may look for another auditor. (I should mention that a similar situation to this occurred with the credit rating agencies in the prequel to the 2008 financial crisis, when the rating agencies assigned high-grade investment ratings to securities that were worthless.)

The second reason has to do with the fact that most accounting firms aren’t solely accounting firms. Most of these firms offer additional services outside of audit. These include services such as consulting, tax planning and advisory, and feasibility studies.

As long as these services are somewhat related to that of a CPA’s, then these firms could offer it to their clients - for a fee, of course. As of the fiscal year 2015, consulting and tax advisory services represented 56% of PwC’s overall revenue, which amounted to $35.4 billion. It is clear that conflicts of interest can arise here, just as they can in any financial market-related institution that engages in different activities.

An auditor’s report that is not up to the expectations of its client can lead to the auditing firm being dismissed from all the services that they provide their client.

3. Be Wary of Your Investment Manager and Advisor:

It is critical to have a sense of professional skepticism when it comes to investing. The industry is largely built on selling promises, with incentives tilted towards raising capital and less so towards long-term over performance relative to a benchmark.

Everyone from fund managers and wealth managers will want to take a share of your capital in the form of fees. Often, their commission is based on management and placement fees, which is a percentage of your capital. A 2% annual management fee on assets of $1 billion is $20 million - not a bad sum for simply raising money.

Performance fees are an additional source of income for the fund, which the fund manager gets if he or she beats a hurdle rate.

These rates are sometimes unreasonably low and easy to beat. Many hedge funds have benchmarks that are close to the long-term average returns of the S&P 500 index, a composite of the largest 500 stocks in the U.S.

Often managers are closeted indexers who charge high fees for somewhat tracking the benchmark.

It is well known that after all fees have been deducted, hedge funds under perform low-cost market indices that they often use as a benchmark.

Note that a 20% performance fee on an 8% return for a hypothetical hedge fund is $16 million - a lower amount than the management fee.

If you compute all the other fees involved in raising and deploying the capital, the majority (if not all) of the fund manager's compensation structure is based on everything other than outperforming.

Not all managers incentives themselves in a misaligned way. During his investment partnership years, Warren Buffett only charged a performance fee on capital that beat his hurdle rate of 6%. This rate, although low, was guaranteed by future years' returns if it was not met in any one year. He did not charge any management fees.

Irrational Exuberance

Irrational exuberance is the term that was coined by Alan Greenspan, a former chairman of the Federal Reserve, to describe market participant’s behavior in the stock market during the later part of the 1990’s.

The meteoric rise in the stock market that occurred during the late 90's is called ‘dot-com bubble’ because of how unjustifiably high stock market valuations for technology and internet-related companies were. The movement of the NASDAQ composite index is an excellent example of how out of whack the market was at the time.

The NASDAQ increased fivefold from around 1,000 to over 5,000 between 1995 and 2001, and then subsequently declined to approximately 1,500 in mid-2001; the crash erased $5 trillion of market capitalization, while the U.S economy grew at an annual growth rate of over 4%. To put this dramatic rise and decline into perspective, the next time the NASDAQ reached the 5,000 level was during March of 2015, almost 15 years later.

One shocking example of the irrational behavior of market participants during the dot-com bubble is the case of Books-A-Million, Inc. which saw its stock price increase by over 1,000% in one week because they announced that they updated their website.

The stock market boom of the 1920’s was another example of irrational exuberance. Those who were invested in the stock market during the 1929 crash shared a similar fate as investors caught up in the dot-com bubble.

Inefficient asset prices identical to the ones experienced during the euphoric periods of 1929 and 1999-2000 don’t happen often. Instead, smaller scale price inefficiencies occur within particular sectors or with individual securities that are very liked or disliked at a point in time.

The Rational Expectations Fallacy

Students of behavioral finance and cognition will tell you that people can be highly irrational, and that investors and academics should at the very least consider psychological factors when participating in or studying financial markets.

As mentioned earlier, social scientists make assumptions about how people behave when creating their models. When it comes to mainstream economic theory, one of these assumptions is that people are rational utility maximizing entities. Professor Daniel Kahneman’s research on cognition has laid the groundwork on why people are not rational in the way that economists believe.

Professor Kahneman specializes in the fields of psychology of judgment and decision-making, as well as in behavioral economics, and was awarded the Nobel Memorial Prize in Economic Sciences in 2002 for his contributions to the field. Professor Kahneman is also the co-author of the best-selling book ‘Thinking Fast and Slow.’

Fast and Slow Thinking

Cognitive psychologists and advocates of behavioral finance will tell you that there are two modes of thinking: fast (or reflexive) thinking, and slow (or reflective) thinking.

Slow thinking is of the type that is analytical and involves reasoning.

Fast thinking is the type of thinking that is driven by instincts and allows people to respond to situations in a matter of seconds.

Fast thinking was frequently useful when humans needed to react quickly to impending dangers hundreds of years ago, but is less useful in the present when making economic choices.

Often, the reflexive system creeps into the decision-making processes unrealized, which leads to suboptimal decisions being made. These systematic psychological errors are called cognitive biases, and some people are more prone to experiencing them than others.

Cognitive Biases

There are many different types of cognitive biases, but for the purpose of this post, I will outline the six main categories that I believe are most prevalent amongst market participants:

The overreaction bias: 

This bias occurs when people overreact to information.

The level of the overreaction is often disproportionately more severe when presented with negative, rather than positive, information.

This can be tied to asymmetric loss aversion, a bias that asserts that a loss of a certain amount is more painful than a gain of the same magnitude.

The overreaction bias results in people selling off their stock holdings in a panic to avoid further losses when expectations aren’t met.

The confirmation bias: 

This bias occurs when people look for information that confirms their original idea. Rather than being objective about a hypothesis by seeking disconfirming evidence, people tend to ‘stick to their guns’ when new information presents itself. Disconfirming evidence carries less weight than confirming evidence.

At its extreme, the confirmation bias can lead to people making non-factual justifications for their decisions.

The confirmation bias can lead to overconfidence, another bias, which affects market participants. In a study where people were asked questions; those who said they answered with 99% certainty were wrong 40% of the time. Overconfidence in one’s ability will lead to unfavorable investment decisions.

The pattern and trend-seeking bias: 

This bias is prevalent in all people since human beings tend to look for trends in all situations, even if none exist.

When a stock appreciates in price for two consecutive years, people may ‘feel’ that the stock will appreciate further, even though there is no relationship between the past and future movement of a stock.

This bias often results in market participants believing that they can achieve superior financial results based on patterns that they see, which would then lead to an under-emphasis on financial research.

Biased information filtering: 

This phenomenon occurs when people tend to focus on specific pieces of information rather than all available information.

People tend to overemphasize the importance of certain types of information, like the most recent piece of information they received or information that is more understandable to them.

Anchoring is a specific type of biased information filtering, whereby more weight is assigned to a particular piece of information, which may not be relevant at all.

People tend to focus on information that generates the most emotional activity. That’s why people decide to participate more actively in the market when significant gains have already been made.

Herding behavior: 

This is a situation whereby people feel comfortable and confident when they follow a crowd. This stems from the belief that crowds know more than any one individual can - a wisdom that was engrained in our biology when deviating from the group meant certain death.

There is also a subconscious feeling of comfort and belonging associated with ‘being part of the pack.’ The idea of being left out produces negative feelings. This bias leads to people selling stocks near the bottom of the market and buying near market tops, and stops them from buying the neglected stocks that may be profitable altogether.

A combination of these psychological forces can result in a negative feedback loop, which reinforces the positive or negative sentiment that exists in the marketplace.

Closing Remarks

The market isn’t efficient, but it's not always entirely inefficient. Let me explain.

Benjamin Graham, the father of value investing, says that in the short run the market is a voting machine, and in the long run, the market is a weighing machine. The implication is that the market as a whole can be predominantly efficient over a long enough time horizon.

Each inefficiently priced security will move towards a more efficient price as expectations become more reasonable. But we cannot say that each security is efficiently priced at any given time.

The market, like a pendulum, swings from one extreme to another, with a disproportionately smaller period of time spent in the middle.

As we have seen, information is never complete, and people assimilate the varying levels of available information differently.

Sell-side analysts recommend stocks that will not perform as well as they claim, and auditors turn a blind eye to the ‘rosier’ financials that companies release.

People are irrational and can overreact to information and circumstances inappropriately.

It is unfortunate that academic economists do not typically draw on ideas from different fields, such as psychology, or include outside influences into their models, because in reality, all else is not equal.

*The time value of money states that the sum of money is worth more now than the same sum of money in the future. A discount rate normalizes this value 'imbalance' of net cash movements over different periods of time.