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Behavioral Finance

Behavioral Finance: A Sneak Peak into OVTLYR’s Approach (Part 6)

By Mahesh Kashyap

Efficient Markets

Efficient Market Hypothesis is the theory that all known information related to an asset is reflected in the asset’s current price by way of the immediate repositioning of rational market participants. Therefore, the current price is always “correct.” In today’s world, it’s true that information arbitrage moves at near-zero latency. As the joke goes, by the time you hear about a hot stock tip, it’s already too late. However, a correct current price can have little relevance weeks or months into the future. This is the nature of speculation, where wins and losses are attributed to luck according to EMH, but there are obvious cases of broader irrationalities leading to market inefficiencies. Nobel laureates Eugene Fama and Richard Thaler discuss this in greater detail in this Chicago Booth Review from 2016.

As you’ve probably guessed by now, another leading criticism of EMH is the dependence on participant rationality. So, what does it look like when some market participants – perhaps even the overwhelming majority – behave in seemingly rational ways while others “go rogue?”

Our internal research as well as that of many other entities reflect similar findings: markets with higher liquidity, and thus greater price discovery, have lesser deltas between top and bottom quartile performance, sometimes approaching but never achieving zero. This would suggest market efficiency is better understood as a distribution variable, not a constant state. Simply, illiquid asset classes like venture capital and private equity exhibit less efficient markets (platykurtic distribution), whereas highly-liquid large cap public equities are much more efficient… but never perfectly so (leptokurtic distribution).