How Wall Street Pros Play the Market
As understanding and acceptance of the basic idea of the Efficient Markets Hypothesis has grown, money managers have had to work harder to convince an increasingly savvy investing public that they need professional help. As a result, many money managers have come to focus on a series of strategies that take advantage of the very real failures of the EMH. What’s interesting is that although these strategies go by a bunch of different names and have a lot of different justifications, they mostly come down to the same thing -- a bet that asset prices will eventually reverse their recent movements.
Financial economists have known for a long time that asset prices fluctuate more than would seem to be efficient. Behavioral finance researchers Richard Thaler and Werner DeBondt found in the 1980s that stocks that have performed well during the past three to five years tend to perform poorly during the next three to five and vice versa. Even earlier, Robert Shiller (now of Nobel Prize fame) found that stock prices as a whole display “excess volatility” -- prices move around more than the underlying company fundamentals that give stocks their long-term value. A number of other researchers have found price reversion over shorter periods of time.
These reversal effects -- which also give rise to momentum effects in the short term -- are some of the most robust EMH anomalies in the literature. As you might expect, many asset management strategies have been developed to profit off of this tendency of prices to revert.
For the most obvious example, consider the Shiller CAPE (cyclically adjusted price-to-earnings) ratio, which historically has been an indicator of whether the stock market as a whole is overpriced or underpriced. Because of excess volatility, if the price of stocks has risen to an unusual degree over the last few years, there are better than even odds that it will fall during the next few. When money managers tell you that stocks are “cheap” or “expensive,” they are probably basing their assertion on the CAPE or something like it.
A less obvious example is the concept of equally weighted index funds. Classic index funds are capitalization-weighted, meaning that each stock’s weight in the fund is equal to its proportion of the total value in the index of which it is a component. This means that when a bunch of people buy a stock and force up the price of all of its shares, its weight in the index -- and therefore, in your index fund -- increases. According to the EMH, that’s OK, since the performance of the index fund will still be the performance of the average dollar in the market, and the EMH says you can’t consistently beat the average. But if prices gyrate more than the efficient amount, a rise in the price is a reason to sell, and a fall in the price is a reason to buy. Equally weighted indices accomplish this automatically. Relative to the average dollar (i.e. the index), they reduce the weight on stocks that have gone up recently, and increase the weight on stocks that have gone down. These are bets on price reversion.
Another example is dollar-cost averaging. This is the practice of buying assets in fixed dollar amounts at regular intervals. If prices are unpredictable, it shouldn’t matter when you buy your assets -- waiting and trying to time the market shouldn’t help. But if prices fluctuate too much, dollar- cost averaging will make you buy fewer shares when prices are high and more shares when prices are low. In other words, dollar-cost averaging is just one more way of betting on price reversion.
A more surprising example may be tax-loss harvesting. More and more money managers are using robots to do automated tax-loss harvesting, which involves selling stocks that have recently gone down in price and buying other, similar stocks that have recently gone down. One benefit of this is that the tax losses allow you to offset some ordinary income, which is taxed at a higher rate than capital gains. But the benefit is much greater if there is reversion in stock prices. If prices revert, buying stocks that just went down is more than just a way to shuffle around tax liabilities -- it’s a bet that prices have overshot and will bounce back in the long term.
So many of the tricks that asset managers have developed are actually part of the same thing. They are taking advantage of one of the biggest and most well-known failures of the EMH -- the tendency of prices to bounce around too much. In the short term, this is a good deal. In the longer term, though, the act of so many managers leaning on these reversal anomalies will act to damp out the anomalies themselves. If more and more people sell when prices go up, prices won’t go up as much. Eventually, money managers will act as a damper on excess price fluctuations, and the EMH anomaly will be reduced. That’s why the logic of the EMH is so powerful, even when it isn’t quite right.
(Corrects seventh paragraph description of tax-loss harvesting. It involves selling shares that have declined, not risen, and buying other shares that recently declined.)
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