Reason #1 Why Markets Are Not Efficient: People Don't Research

Last update on Aug. 21, 2013.

"The best argument against democracy is a five-minute conversation with the average voter." - Winston Churchill

The 'Efficient Market Hypothesis' (EMH) is like a religion. Believing in it has a dramatic influence on the way you actually invest. Plenty of financial advisros believe in EMH, which makes this subject very relevant for us. In this series, we discuss what EMH is, why it's wrong and why that matters.

In part 2, we discussed the academic literature in support of EMH, and the implications of believing in EMH. In this installment, we give you one reason why it's wrong:

People are stupid.

The Story Of TRE

On early June 2011, a company called the 'Tanzanian Royalty Exploration' saw its stock plunge by over 8% in 4 days. Usually, this happens when there's a major announcement or if the market as a whole was panicking. But neither was the case. The real reason?

Ticker confusion.

About the same time that Tanzanian Royalty's stock plunged, another company was making the headlines. That company's name was Sino-Forest. Sino-Forest was a forestry company that had assets in mainland China. Then one day, an independent stock researcher named Carson Block of Muddy Waters published a devastating report that exposed Sino-Forest as a fraud.

Since that time, Sino-Forest shares plunged from over $20/share to around $5/share (they eventually declaring bankruptcy). This was a big deal. At its peak, Sino-Forest was worth over $6 billion. Many people lost a lot of money on Sino-Forest.

Sino-Forest's ticker symbol was TRE. In other words, if you wanted to buy or sell Sino-Forest shares, you had to punch in TRE in your brokerage account.

Kind of.

Since TRE was traded on the Toronto exchange, if you wanted to trade Sino-Forest stock on Questrade, you had to punch in TRE.TO, not TRE. As an aside, this is why I always include the '.TO' when I mention Canadian ticker symbols on this website.

If you had punched in 'TRE' without the '.TO' and sold it, you wouldn't have sold Sino-Forest. Instead, you would have sold Tanzanian Royalty Exploration shares, which used to trade on ticker TRE.

Many people presumably saw or read the news on Sino-Forest, and then rushed to their computers to sell the ticker symbol they saw, which was TRE. This caused Tanzanian Royalty's stock prices to plunge.

Why This Example Contradicts EMH

According to EMH, this shouldn't have happened. As we've noted in earlier installments, EMH assumes that people do very thorough research on every stock before making any significant investment decision. Not doing so causes markets to become inefficient.

Let's see why. For example, let's say we have company XYZ. If you read and digest every information on company XYZ correctly, we will arrive at the value of $20/share for the company.

If XYZ trades at $15, savvy investors buy up XYZ until its stock goes up to $20, at which point the savvy investors stop. If XYZ trades at $25, the opposite happens and savvy investors sell, until it trades at $20. In other words, XYZ's true valuation acts like gravity, pulling prices to its true value.

But what happens when there are, ahem, dumb investors who think XYZ is worth only $10? Those dumb investors will sell XYZ when it's at $15, while savvy investors buy them up at $15. Where will prices actually go? The answer depends on who has more cash - dumb investors or savvy investors.

If there are more dumb investors than savvy investors at a given time, XYZ's stock price actually move away from its true value.

This was the case for Tanzanian Royalty. There were more dumb investors who got it confused with Sino-Forest, than those did the research. Tanzanian Royalty didn't have enough faith in the market's wisdom to restore its share price, so it spent money and changed its ticker symbol instead.

But Surely, Funds Are Smarter?

The Tanzanian Royalty example is an obvious case of stupidity. But how often are stocks mispriced because of investor stupidity? To answer this, let me ask you another question: Among the people you know who invest in stocks, how many people actually reads financial statements and other company filings, and actually understands them?

Very, very few.

You might say this isn't a fair statement, since most money is not with individual investors. Rather, they're with big funds, who have massive armies of business school grads trained to read and understand financial statements and the like. Surely, those guys make the markets efficient.

That was definitely my expectation when I first started working for my previous employer. To give you a brief background, I worked as an oil and gas analyst for a top performing fund for 2 years. By top performing, I mean a fund that would place in the top 1% of Canadian funds, if it made its track records public.

At first, I didn't really understand how the fund could pull off such great results year in, year out. But then it became clear. Our competition sucked.

At my firm, I read everything I can about oil and gas, paying particular attention to its economics. We cross checked figures in financial statements, and made spreadsheet projections. We tested every assumption, and we were rational about everything.

When we went to oil and gas conferences, we knew what to ask oil and gas executives. How much oil do you really expect to pump out? Are your costs rising or falling, etc. We'd also try to share ideas with other fund analysts, but do you know what we'd get?

Blank stares.

They had never even heard of half the concepts that I think are essential. Instead, they throw around superficial terms like production growth, etc that really didn't tell you much about the economics of each company. To be fair, it's not that they're necessarily dumb. As you'll see in later installments of this series, there are other factors at work that prevent funds from investing rationally.

Conclusions

Here's the inconvenient truth for EMH advocates. Market participants are just not that smart. Having dumb market participants make the markets inefficient, often significantly so.

The markets function like a democracy. But instead of ballots, investors vote with their money. Unfortunately, as Churchill said, the best argument against democracy is the intelligence of the average person. Likewise, one of the best arguments against EMH is the intelligence of the average investor.

In the next installment, I will discuss another major reason why markets are not efficient: because the average humans are emotional. In the meanwhile, before you jump into an individual stock,

Do your research.

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