Amidst the recent uptick in volatility, an important question resurfaced: are markets efficient? People on each side of this issue now share a Nobel Prize so the debate is far from straightforward, but wide swings in wealth without change in economic fundamentals provide ample support for its relevance.
When approaching the subject it is useful to consider what markets are made of and how they arrive at a price. Transactions provide prices that are the result of the decisions of market participants. Because anyone can buy or sell, markets are theoretically efficient, but this assumes participants act rationally when processing information. It is at thisjuncture that markets become prone to inefficiency.
If all participants have access to the same information and the means to process it rationally, they should in turn make rational decisions. By this logic, with expanding access to information markets have become increasingly efficient. At the same time, increased information has amplified the noise surrounding markets. Noise makes it difficult to process information in a rational way.
Recent events have demonstrated that irrational behavior persists among market participants. Over the first three weeks of 2016, stock markets lost close to $8 trillion despite the continued growth of the global economy. While news related to oil, emerging markets, and Fed policy was substantive in some respects, there were no fundamental changes over such a short period of time.
The most efficient way to separate market signals from noise is, unsurprisingly, using computers. Removing emotion from trades and testing signals with data allows computers to act rationally when humans cannot. Akin to other industries, investment management is inclined toward computerization of its workforce, and this process is set to continue as systematic investing moves mainstream.
When logic is programmed to make rational decisions, markets should naturally become more efficient. The risk is the same for any system – garbage in, garbage out – so noise remains the primary challenge to market efficiency.
In this context, markets will continue as a superior but imperfect solution for aggregating information efficiently. We will move closer to this goal through technology, but never reach true efficiency given the barrier of noise.