Are investment markets rational and efficient?

In the 1960s celebrated American economist Eugene Fama conceived his Efficient Market Theory (EMT), a hypothesis which promoted that investment markets are ‘informationally efficient’ – that all publicly available information is rationally processed by investors and reflected in the price of a security or asset. 

It’s an intriguing idea, yet the theory was effectively disproved by a number of super-investors, including Buffett, who outperformed the market rate of return without taking on great risk year after year, for decades.

The response from the efficient market theorists was that the markets are nearly always rational, but sometimes not.

Buffett poured scorn on this retort, noting that the difference between a markets being always rational and sometimes not “is like the difference between night and day.”

Ultimately, markets are not totally rational because they are driven by the human emotions of fear and greed.

Humans are not rational beings, and consequently, market pricing is sometimes inefficient too.

The lesson?

Restrict investment acquisitions to when the market is despondent and has undervalued assets.

EMT in the stock market

With thousands of investors processing information it may seem impossible for investors to identify materially mispriced stocks.

For average investors, this may be so, but as the stock market represents a highly liquid asset class it tends to overshoot fair value both at the peak and the nadir of the market cycle.

Thus when Price-Earnings (PE) ratios fall into single digits, this is when investors should stockpile holdings in quality companies.

Residential property: an imperfect market

We know that residential property is an imperfect market, and here are four of the reasons why:

1 – Not exclusively an investment market –

While in the stock market all securities are held by investors, in property around two thirds of properties are retained by owner-occupiers. ‘Mums and Dads’ are more likely to price assets emotionally than (theoretically) rational, professional investors. 

2 – Distressed sales –

Residential property is usually associated with leverage or borrowing which can lead to forced sales and the mispricing of assets.

When unemployment levels rise, the volume of mortgage repossessions tends to increase too.

Investors should not look to take advantage of individuals in financial distress, but it is sometimes true that vendors are happy to be freed from the shackles of mortgage repayments and will accept a discounted sales price.

3 – Market cycles –

Just as the share market is ruled by fear and greed, the property market is ruled by human emotions and thus moves in cycles.

Investors should look to buy counter-cyclically when bargains abound.

4 – Potential for improvements –

Owner-occupiers may not have the time, money or inclination to renovate a property and force appreciation.

In the case of a major development, subdivision or rezoning only a skilled investor might have the vision to conceptualise an improvement and carry it through to completion.

Let’s close out with Buffett 

Intrinsic value investors Benjamin Graham and David Dodd believed that inefficiencies will always exist in the market as detailed in their wonderful 1934 book Security Analysis.

As Buffett famously once said:

“Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”