By Nicholas Haberling
Preamble: This is the first of our opinion articles. You will notice that unlike our Theorycraft posts there are no sources cited. The hope is that writing these articles will be less time consuming and research intensive, thus allowing us to post more. Naturally, opinions may change over the time.
For this thought experiment we must make the assumption that semi-strong form efficient market theory is true, that markets rapidly absorb new information and that the cost of trying to obtain monopolistic information exceeds the potential gains from having it. To some this may be a bold assumption but studies show that fund managers who beat the market between 5-10 year periods do not remain the same.
Commentary on Efficient Markets, Information Accuracy and True Value
It should also be pointed out that the presence of a bubble in a given market does not mean markets are inefficient. We need to have a mental separation between efficiently absorbing information and what true value is. While finding true value is the ultimate goal, when that doesn’t happen it doesn’t disprove efficient markets. A historical example would be our understanding of the solar system. Historically, every culture on the planet believed the sun, moon, stars, and planets revolved around the Earth. All available information, the Earth appearing to be a fixed location from the point of view of an observer while the sun, moon, and planets shifted in the sky, pointed to the Earth being the center of the solar system. For all intents and purposes for this scientific theory the market was efficient and at true value. Except there was a bubble. With the invention of the telescope we could better observe our place in the solar system and soon realized we were not at the center; the sun was. However, previously for 10,000+ years there was a high cost to this information/technology that no civilization could achieve, therefore any attempt at trying to access this information would have been a waste of resources, leaving you at the same place as your cultural competitors or even worse off. Naturally with his new information though, the marketplace of ideas quickly adopted the sun being the center of the solar system and now at least in this case, the market’s belief reflects true value.
Now what does this historical example and I would say common sense show? That a discrepancy between the efficient market and true value is the result of information accuracy. In my opinion, information accuracy is the relationship between observation technology, analysts and communication technology. Observation technology is simply the instrument you are trying to use to find information while communication technology helps reduce the time it takes to absorb that information. This can be written out as:
IA = f (observation technology, analysts, communication technology)
To use our historical example IA = f (observation technology (telescope, celestial observations), analysts (Galileo, Islamic astronomers), communication technology (writing, horse letter carrying))
An increase in any of these three factors will reduce the discrepancy between the efficient market price and true value. I don’t think anyone would find this surprising. Essentially, as technology improves and more analysts enter the market, the closer market price will be to reflecting true value. However, market price will never equal true value because of this:
True Value <> market price = f (IA, participation)
There is a phenomena in science when you try to directly observe dark matter, you alter its location and therefore it cannot be observed. You can only observe its effects and then deduce its presence. A similar scenario may exist in the market. Here, it may be possible to observe true value. However, by simply trying to act on your belief and participating in the market, you push price ever so slightly away from true value. Of course depending on your ability or inability to move the market this could be meaningless. But it’s an interesting idea that even if you correctly predict true value, just by trying to act off of that prediction you won’t be able to maximize profits to the extent you predicted.
Diminishing Marginal Returns
So after reading all that you might say, “Cool observations, but what’s the point?” A key tenant of efficient market theory is that it may be possible to beat the market with monopolistic information, however, the cost of attaining that information would likely exceed the benefit you get from having that information.
I will admit there are a lot of big “ifs” involved here. But let’s say that technology improves so much that Information Accuracy becomes 100%. That the collective knowledge of all investors, the idea of diversification of thought, leads to price reflecting true value. I know, a big “If.” Then at that point the only discrepancy between true value and market price is if you act on that information because participation creates price reverberations that alter the overall calculation.
If this world were to happen, it is fair to say that wiggle room to produce returns greater than the market is incredibly small, far smaller than even today. But costs to acquire this information would still exist. So why spend money to get information (fixed costs, time, employees, etc) when even if your information is accurate, the cost of acquiring it is more than the potential gain of being a simple index investor?
The Investors’ Dilemma
This is where the Prisoner’s Dilemma comes in. I’m just going to pull it from Wikipedia for the sake of brevity:
“Two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement with no means of communicating with the other. The prosecutors lack sufficient evidence to convict the pair on the principal charge, but they have enough to convict both on a lesser charge. Simultaneously, the prosecutors offer each prisoner a bargain. Each prisoner is given the opportunity either to betray the other by testifying that the other committed the crime, or to cooperate with the other by remaining silent. The offer is:
If A and B each betray the other, each of them serves two years in prison
If A betrays B but B remains silent, A will be set free and B will serve three years in prison (and vice versa)
If A and B both remain silent, both of them will only serve one year in prison (on the lesser charge).”
Our investor scenario is similar but slightly different:
There are two Active Investors and the free riders (index investors). The Active Investors will be referred to as A and B.
If A and B both practice active investing, they each have a small chance of outperforming the market and a greater chance of matching or underperforming. Free riders get a 10% return.
If A practices active investing, but B joins the free riders, A’s chance of beating the market goes up, and since the market has lost an analyst, overall information will not be as accurate. Therefore B and the free riders have a 9% return (arbitrary number to take into account loss of information accuracy from reduction in number analysts). This works vice versa.
If A and B both join the free riders everyone receives a 7% return(arbitrary number to take into account loss of information accuracy from reduction in number of analysts)
To tie this into the idea of diminishing returns: collecting information not only has a dollar cost but the very act reduces your chances of beating the market since the market also benefits from the information you collected.
If you subscribe to active investing I think this brings an interesting dilemma: if you actively invest you are less likely to beat the market. However, if you move to passive investing, not only does the market losing your information hurt information accuracy and thus free rider returns (which you now belong to), it actually benefits your competitor since the drop in information accuracy increases price discrepancy.
Essentially you’re not likely to win and if you don’t participate you are certainly not going to win (in terms of achieving higher than market returns)
What’s the Point
I think what this thought experiment ultimately shows is that as information accuracy improves, the likelihood of beating the market becomes more a matter of chance as participation becomes the predominant factor. This is important for investors to understand. Portfolios are constructed around investor goals. If your goals can be achieved through market or lower returns then your financial future is secure. If they require higher than market returns I think the issues here are obvious: in order to beat the market you must overcome the actual cost of acquiring market beating information as well as the price reverberations enacting this information introduces into the market. But then again if you don’t enter the arena you can never win.