Only academics believe in efficient markets
How do investors think about financial markets? If you study finance at university, your teachers will tell you that markets are efficient (or at least largely efficient) and that any new piece of information is instantly incorporated into the share price of a company. Hence, looking at past news about a company should not influence your investment decision. But if you ask retail investors or financial professionals, that is what happens.
Peter Andre and his colleagues conducted lab experiments where academics, financial professionals, retail investors, and members of the general public were invited to invest in different stocks or the stock market overall. The setup was quite simple. Investors were provided with good or bad news about a company that had been released four weeks ago. Then they were asked to predict the future return of that stock and interviewed about their reasons for making that forecast.
The results are summarised in the chart below. Essentially, the vast majority of academics followed the prescriptions of the efficient market hypothesis and did not change their forecasts in response to old news, good or bad. They argued that this information was fully reflected in the share price and hence has no impact on future returns.
Reasoning underlying forecasts by different investor groups
Source: Andre et al. (2023)
Financial professionals, retail investors, and members of the public alike changed their return expectations in response to this news. If the news is good, they increase their return expectations even if that news item was released four weeks ago. If the news is bad, they reduce their return forecasts.
The main argument for doing so is the persistent impact of the news on future earnings and dividends. They argue that because of the good news, earnings growth should be stronger, which should result in higher share prices going forward, etc.
Academics would reply that this is a circular error because the increased future earnings are what has driven the share price higher already.
But I would argue that the academics are wrong. Or rather the efficient market hypothesis on which this academic view is based is wrong. There is plenty of evidence that behavioural effects lead to ‘market inefficiencies’. One of these is herding and many studies have shown that analyst up- and downgrades of earnings do not happen in a vacuum. Rather, analyst up- and downgrades come in waves. And these waves influence share prices and create lasting price trends. To see how this works in practice look at this op-ed by Mark Hulbert or at this recent academic paper.
And that is why it makes sense to anticipate higher returns in response to positive news even if that news is somewhat stale. Real markets aren’t all that efficient and certainly not as efficient as academics want to believe. Rather, markets are messy, part psychology, part fundamentals. And unless you incorporate the psychology of markets and investors into your investment process you are almost certain to fail as an investor.
There is an interesting paper (Gode & Sunder 1993) in which it is argued that a market made up of non-intelligent players would also be efficient. That is, efficient in the sense that it would, over the long run, come to the same equilibrium as an intelligent one. This means inductive proof of the efficient market hypothesis is not possible, as a conventional market would be indifferent towards the rationality of buyers and sellers in its long-term behavior.
Academics live in a "should" world, not an "is" world. Should is a wasted word.