“Can you really beat the market?”
‘The house always wins’ or ‘You can’t beat the house’ is something we all must have heard, especially the casino lovers who like to test their luck once in a while via gambling.The statement is very much true. A casino is a business, not a charitable organization throwing free money away. It has a business model in place designed to ensure its profitability.
With this thought in mind, let us take a step ahead and discuss the same for financial markets and examine to what extent the saying, ‘You can’t beat the market’ stands valid.
This has been a heated debate ever since the economist Eugene Fama coined the term “Market efficiency” while stating one of his hypothesis in 1970.
What is Market efficiency?
Market efficiency refers to the degree to which market prices fully, quickly and rationally reflect all available, relevant information. If markets are efficient, then all information is already incorporated into prices, and so there is no way to "beat" the market because there are no undervalued or overvalued securities available.
In an efficient market, all securities trade at their intrinsic value at all times with no scope of earning abnormal profits.
So,the only way to mint a few bucks is to take more risk, as the expected return on any security would equate to return necessary to compensate one for that risk.
Degrees of market efficiency:
By now, most of us would have realized that ‘Information’ is something which plays a key role while discussing efficiency and what it is all about. But what kind of information are we really talking about here? To answer that, there are basically 3 types of information and its availability based on which Fama stated Hypothesis classifying Market efficiency under 3 heads:
Now that we understand what the Hypothesis by Fama really is, lets try to examine to what extent are we able to reject it or fail to reject it and what the differing believes around the same are-
Differing Beliefs of an Efficient Market:
Investors and academics have a wide range of viewpoints on the actual efficiency of the market. Believers in strong form efficiency agree with Fama and often consist of passive index investors (where a portfolio of stocks with the exact weight as it has in the benchmark is created for investments).
But the presence of prohibition on Insider trading makes you think that it is very difficult for price to reflect all private information and with a considerable amount of conviction allows you to reject at least the strong form efficiency.
Practitioners of the weak version of the EMH believe active trading can generate abnormal profits through arbitrage which ultimately helps in achieving efficiency once it is exploited, while semi-strong believers fall somewhere in the middle.
People who do not believe in an efficient market point to the fact that active traders exist. If there are no opportunities to earn profits that beat the market, then there should be no incentive to become an active trader. Further, the fees charged by active managers are seen as proof the EMH is not correct because it is necessary that an efficient market has low transaction costs and that the information in general must be available to all.
So, if we circle back to the point from where we started,” Can you beat the market?”, or is it that Fama correctly described the markets and that your fate is already decided? Well, truly speaking there is no definite answer to it. It really boils down to what an individual believes in. Not only the belief of an individual, but the market under consideration upon which the hypothesis is being tested makes a huge difference. Whether or not the market is available to you at low transaction costs or is the market developed and many such factors will ultimately decide the extent to which Fama was correct or not correct at all.
At the end I would say that it’s the beauty of finance that it is grey, there is no black or white, no right or wrong. The hypothesis might stand correct for some markets and for some it may not even consist a grain of truth. For a casino, the odds are completely against you, it’s only by chance on a day or two that you are really able to profit.
For markets, to say that you can’t beat it or you can beat it, with utmost certainty is next to impossible. The best we can do is to accept the ambiguity of it and rely on the study we know best or we believe can help us maximize our returns.