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Capital markets are generally efficient

Capital markets are generally efficient

Capital markets are the best mechanism we have to calculate the value of an asset. The value of that asset should reflect its potential future return. Many investors believe that they are able to price assets more accurately than the market.

Investors perform research and analysis to arrive at a price for an asset. If the market price is below their calculated price, they might buy that asset to make a profit when it rises. But, however carefully they make their calculation, they never base their prediction on more than an estimate. Some estimates will be right and some will be wrong.

Research shows that very few people are able to make consistently accurate estimates over a reasonable period of time. For this reason, we do not use predictions about markets or prices in our portfolios. 

We apply this principle across our investment philosophy, which means that we do not buy individual stocks that we think will outperform the market; nor do we weight investments towards countries or regions that we expect to do well. Instead, we use investment funds with broad exposure to the whole market and allocate assets to countries in proportion to their relative size in the global market. 

We therefore accept that the market, powered by the wealth-generating capability of capitalism, provides an adequate rate of return. We do not try to beat the market with predictions; instead, we harness the returns of the market through discipline and structure.

The Efficient Market Hypothesis

The astute investor will constantly search for alpha within the market; the opportunity to realise gains from market inefficiencies has been a dominant strategy for many years. To this day, many investors will scour financial newswires and data feeds, analyse company financial statements and monitor potential deals and mergers. 

The aim is to identify the opportunities for arbitrage or find stocks which are over or undervalued on the stock market relative to their actual value. This strategy revolves around the idea that markets are generally inefficient and thus there will always be value to be found given the correct knowledge and market timing.

However, around the mid-twentieth century, this idea come under scrutiny as a number of academics began to question the nature and efficiencies of financial markets. Although there had been prior research surrounding the topic, Eugene Fama published a landmark paper in 1965 in which his empirical analysis concluded that stock market prices follow a random walk[1]. He went onto explain that, given his conclusions regarding stock market movements, there were questions to be asked of both technical and fundamental analysts. 

He continued his research in 1970 with further empirical studies[2] and concluded that an efficient market is one in which prices fully reflect all available information. The concept of the Efficient Market Hypothesis (EMH) has since steadily gained momentum.

More recently, following the stock market crash of 1987, the internet bubble of the 1990s and more recently the events surrounding 2007/08, many questions have been raised regarding the validity of the theory. 

Recent events have suggested that there are, in fact, inefficiencies within the market and thus fundamental analysis remains a core component for investor gains. However, in his book, A Random Walk Down Wall Street[3], Burton Malkiel illustrated that although the market may exhibit periods of inefficiencies, one cannot consistently outperform market averages. 

In other words, while active fund managers will periodically outperform the market average, the probabilities of such an eventuality diminish over time and consistently above market returns become unlikely. 

As a result, the longer the time horizon the more prevalent the EMH becomes and thus, given our approach that investing is for the long term, our belief remains firmly within the efficient market.


[1] Fama, E. (1965) The Behaviour of Stock Prices

[2] Fama, E. (1965) Efficient Capital Markets A Review of Theory and Empirical Work

[3] See “A Random Walk Down Wall Street: Including a Life-Cycle Guide to Personal Investing

Contact our wealth team

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Regent Square
Doncaster Road
Kenilworth 7708
Cape Town
t: +27 (0) 21 657 2120

United Kingdom

Castlewood House
77/91 New Oxford Street
London
WC1A 1DG
t: +44 (0) 20 7759 7514

Australia

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9 Yarra Street
South Yarra
Melbourne VIC 3141
t: +613 (0) 86 514 500

Hong Kong

Level 1102
The Lee Gardens
33 Hysan Avenue
Causeway Bay, Hong Kong
t: +852 3959 8681

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