View more on these topics

Efficiency and risk

The theory of efficient and rational markets seems to have been borne out by volatility during the crunch

Jason Witcombe Best Advice

You have talked in the past about markets being efficient and that there is little value to gain by trying to time them. Has recent stockmarket volatility changed your view?

The efficient market hypothesis, developed in the 1960s, states that an efficient market is one where, given the available information, actual prices are a very good indicator of intrinsic value. Prices are always changing as new information arrives.

When new information hits, prices change rapidly as a result. For example, when there is bad economic news, share prices tend to fall as investors downgrade their expectations of future profits.

Often, private investors looking on from the sidelines may see a news headline that reports poor economic data but share prices rise. This is generally down to market relief that the data was better than economists and analysts had predicted.

Given that the collapse of Lehman Brothers was just over a year ago, it is worth revisiting that episode.

At the time, investors were worried there would be a complete breakdown in the global financial system. Listening to interviews now from many of the key decision- makers, it seems such fears were justified.

There was a real prospect of the global economy entering a depression with long periods of substantially reduced earnings. It is hardly surprising that share prices around the world collapsed.

However, as events panned out and central banks took the actions they deemed necessary, expectations were revised again and markets have since partially recovered. This does not mean previous prices were wrong, as they reflected the information at the time.

Eugene Fama is one of the names most commonly associated with the creation of the efficient markets’ hypothesis. He believes markets have behaved rationally throughout the credit crunch. In a recent podcast, he said: “The market can only know what is knowable. It cannot resolve uncertainties that are not resolvable. So when there is a large amount of economic uncertainty out there, there is going to be a large amount of volatility in prices. And that is what we have been through.

“As far as I am concerned, that is exactly what you would expect an efficient market to look like.”

Recent research from Fidelity shows that the average annualised return of the FTSE All Share over 15 years was 6.13 per cent a year. Missing just the best 10 days in this period would reduce this figure to just 1.91 per cent.

Naturally, if you missed the 10 worst days, you would significantly outperform the market.

However, without a crystal ball, that is only possible with the benefit of hindsight. It is like betting on a horse race after the winner has passed the finishing post.

Unless you are very lucky, it is extremely hard to do better than the markets on a consistent basis.

What does all of this tell us? Put simply, it makes sense to have diversified portfolios to remove avoid- able risk and the only way of varying returns over the long run is by changing your risk appetite. If you want big returns, you need to take the risk. Markets may not be perfectly efficient but they are pretty close.

Jason Witcombe is a director of Evolve Financial Planning


News and expert analysis straight to your inbox

Sign up


    Leave a comment