The paradox of Market Efficiency

Efficient market theory states that the price of all stocks trading in the stock market is already priced in, so you don't need to actively research about the stock because every good news or bad news that could possibly be there is already reflecting in the stock. So basically, nobody can beat the market because the market has already processed every bit of information. The possibility of outsmarting the market is considered impossible by this theory.

The Finology view

Even if we believe that the market knows everything and the price is the reflection of the consensus view of the market, what is the guarantee that the consensus view is actually correct ? When even in a family discussion regarding renovating your house or deciding which colour to paint your room, there are 5 different views and the consensus view need not be correct, how can we trust the view of the market which is simply the aggregate of thousands of individual opinion.  Don't we then have the opportunity of beating the consensus by being smarter ?

The most efficient market

Actually, the theory of Efficient market is a paradox in itself because if anything it has only contributed in increasing the inefficiency in the market because people have started believing in this Efficient market theory and therefore, they are investing in passive funds. These funds  mimic the composition of the index. Under the belief that one cannot outsmart the market, there are less and less people in the field of active management and the fewer active managers we have, the lesser is the efficiency in the market. With this drift towards passive investing, we can be sure that market will only become more inefficient.

Mob at work

We have often heard that mob psychology is dangerous. Market is nothing but mob  trying to outdo each other. Although, to consider the market foolish would be foolish on your part because market is neither inefficient nor efficient, it only fluctuates between the two extremes so  it's important even for active managers that the market remains efficient to a large extent because only then can they hope that the stock which they deemed undervalued will eventually be noticed by the largely Efficient market which will lead to its appreciation.

Risk and Return are not always proportional

The theory says that if you outperform the market by 10%, you have to take that much extra risk. So, any extra return that you generate is explained by the extra risk that you take and there is a direct link between risk and return. The more you take risk the more return you generate.

Value investors believe in the low risk high return approach to investing under the belief that it is the inherent nature of the market to rise, so if you only take care of the losses, the winners will eventually take care of themselves.

Let’s take the Wipro example -  in the last 30 years, Wipro has given returns of 40% CAGR, but was Wipro the most dangerous stock in the market 30 years ago ?

Similarly, if we pick out the best performing stocks in the last 5 years such as Page and Eicher and ask ourselves if these were the riskiest stocks ?  I am sure the answer would be a resounding “NO” and this helps us in reaching to the conclusion that increased return is not always explained by a proportional increase in risk.