"The efficient markets hypothesis was a half-step forward, for it is a half-truth."
- Robert J. Shiller, Nobel Laureate
Market efficiency is a classic topic in academic circles and frequently a subject of great debate in finance. The trouble with academic debate is that it can be dismissed as esoteric jibber jabber most of the time. Most of the time it is of minimal relevance to individuals and institutions. Market efficiency is different; it has a tremendous amount of relevance. We, at TWP, think its time to make it relevant.
Consider where you are in life- young, old, or somewhere in between. Do you have children, grandchildren, friends and/or family for which you are financially responsible? Market efficiency is relevant at each turn in your financial life. Why? It effects how you approach financial decisions and assess risk. Whether we are talking about addressing a string of liabilities in the near future or further down the road, considering a career move, making a large gift/ charitable contribution, or just making smart, rational financial decisions on a daily basis, the ability to identify and evaluate risks is the single most important factor in determining the objectivity/ efficiency of your decision.
The trouble with market efficiency is that it inherently assumes a “normal” distribution of outcomes. Please don’t let your eyes glaze over now; you have made it this far and I will do my best to illustrate… This is simply to say, the positive surprises equally offset the negative surprises or “shocks” shall we say. There are a number of implications for this assumption, but for the purposes of today’s note, we will only focus on a couple of them.
First, what is normal? From a psychological standpoint, Freud couldn’t tell you and from a statistical standpoint, a bell curve has pretty limited value, too. Normal changes and those changes or transitions rarely happen efficiently. There is generally some volatility- a recalibration of risk(s). Consider human history. Have we always made the best, most rational decisions? Of course, not. History is littered with bad decisions, irrational behavior, largesse, exuberance, depravation, disease, famine, war, and abuse. Some of these things we control but many we can’t, don’t, or won’t- like Jekyll’s limited influence over Hyde. Incidentally, who do you remember more: Jekyll or Hyde? Where do problems tend to cluster? At the skews or said differently, at the times of euphoria and despair.
It is important to take a breather here and look at two very important terms: skew and cluster. Cluster is a very important term because it addresses the uniqueness of outcomes rather than overplaying the similarities of outcomes. The trouble with simply looking at the similarities of outcomes is that it inevitably leads down the slippery slope of prediction. People cannot predict, period. It is a fool’s errand. Each outcome is unique, full stop. This is a subtle tip of the hat to Stephen Hawking’s work. So, what can we do? We can assess the likelihood of outcomes. As an outcome becomes more or less likely, we should adjust appropriately in real time.
The only way to predict is to control an environment entirely and that means having the ability to manipulate each individual component that makes up the environment. So, we need control first and foremost and access to perfect information and the ability to accurately interpret the information in real time and in order to insure the replicability of our experiment (and our own credibility), we must be able to recreate the environment. I’m pretty sure no one reading this can do that. Sounds a bit superhuman.
Skew. Life is about skews. We do the best we can with the imperfect information we have at our disposal, not to mention our own personal biases and the limited time we have to make a myriad of decisions. Moreover, the way that I will interpret data is unique to my perspective. Think of it like still life art- same object, different perspectives, different pictures. Each perspective is governed by many different factors- the weightings of which change over time. We will not address this today, but suffice it to say each perspective is unique.
Uniqueness contributes to the skewness of life. Some skews are good, some not so good. We do not know how long a particular skew will persist or diminish, that is our lot. So, if we looked at this through a market/ financial lens, you could say that we do not control the returns/ outcomes, but we can control the degree to which we are exposed to risk over time. We know there are good times in the market where investors are compensated for risk and times when they are not. Risk should always be considered a cost because you can control the costs you incur- at least to an extent. The degree to which you are compensated for the costs incurred determines efficiency. In sum, the lion’s share of returns over time will be governed by the ability to manage risks as they emerge rather than overreaching attempts to predict outcomes.