Why It Is Possible to Make Above Average Returns – Even in Efficient Markets

There is a well-known hypothesis in financial economics, called the Efficient Market Hypothesis (EMH), that spawns a lot of debate. The EMH states that financial markets are ‘informationally efficient’. In other words: a financial asset’s market price always incorporates and reflects all available relevant information. Hence no investor can consistently use such information to find stocks that earn him above average returns. After all: such information is already reflected in the asset’s price; so if there is a lot of ‘positive’ information about the company, the stock’s market price will have increased, and if there’s a lot of ‘negative’ information, the price will have decreased.

I want to make an argument why, even if the EMH holds, it might still be possible to consistently earn above average returns on investments. The argument is basically very simple. Let’s first recall the EMH. We know that an efficient market is a market in which the price of a financial asset (let’s say a stock) always incorporates and reflects all available information. Hence, you cannot benefit from the set of available information in such a way that you can consistently earn above average returns on investing in the asset – or any asset for that matter. But does it follow from this that you cannot consistently achieve above average returns? I don’t think so.

Because what if you are consistently better than other investors in anticipating future information? Then, even though the stock’s market price reflects all available information, you can utilize this anticipated future information to decide whether to buy or sell a stock. And if you can anticipate future information (which is information not yet incorporated and reflected in the stock’s price) better than the average investor, then you can earn above average returns, time after time.

This all sounds pretty abstract. So let’s look an example. Suppose there is a stock of a company that produces wind turbines – call it ‘stock A’. Furthermore, let’s suppose that at this point in time investors are on average not confident about wind energy’s potential. They might think that the cost of producing wind energy is too high, its profits depend solely on the current regulation, or that it will still take a long time before our fossil fuels are depleted, making the switch to wind energy not urgent yet. Given these considerations the stock trades at a price of – let’s say – 10. Let’s assume that this price indeed incorporates and reflects all available information – such as information contained in annual reports, expert analyses etc. Hence it seems reasonable to say that you cannot consistently earn above average returns on this stock by utilizing only this pool of existing information.

But what if you believe that, given the ever increasing energy consumption and ever decreasing level of fossil fuels, society has in the middle-long term no choice but to turn to alternative forms of energy – forms such as wind energy? If you think this is true, then you can anticipate that any future information about the wind-turbine producer will be positive – at least more positive than today’s information is. You can anticipate that the future information will show an increase in the firm’s revenues, or – for example, in case the firm is close to bankruptcy but you know that its managers don’t profit from a bankruptcy – a decrease in costs. Given that the market is efficient, you know that at the time this information will become public, the market price of the stock will increase to reflect this information, to a price of let’s say 20. If you can anticipate such future information consistently, then you can anticipate the future stock price consistently, allowing you to consistently earn above average returns – despite the perfectly efficient market.

An equivalent way to look at this matter is to say that you take into account more information than the average investor in calculating the stock’s fair value. Let’s say that you are doing a net present value calculation, and you have estimated the firm’s future cash flows. In case of stock A, investors used estimated cash flows that lead them to a fair value of 10. However, given your anticipation of future information, you estimate these cash flows to be higher – leading you to a higher valuation of the stock. Again: if you can consistently anticipate future information better than the average investor, you can consistently earn above average returns – even in an efficient market.

Exams In the Summer Term: The Optimal Option?

Most universities in the United Kingdom apply what is called the “trimester-structure”: the division of the academic year into a Michaelmas, Lent and Summer Term. In general, although this differs per program and per university, it is the case that by far most of the examinations are due in the Summer Term. The question is: is this the optimal educational structure? There are, I think, at least two main problems with the structure as it is currently being applied: one regarding its didactic implications, and one regarding its (in)efficiency.

Let’s start with the didactics. As numerous scientific studies have shown, feedback – and especially immediate feedback – are of great importance in the learning of new material. This is because, when mastering new material, it is important to be made aware in an early stage of errors that – if not resolved – might turn into significant problems. And although immediate feedback is part of most lectures and seminars, there’s one crucial area in which this aspect seems to be ignored: examinations. As mentioned before, an intrinsic part of the trimester-structure is that by far most of the examination takes place in the last term (i.e., the Summer Term). This implies that material studied in the first term (Michaelmas Term) gets tested in the third term (Summer Term). It seems reasonable to assume that, in this case, the feedback period between absorbing the material and the material being tested is very long (a couple of months), and therefore lacks the impact it could have upon correcting students’ knowledge.

Besides a didactic argument, one could employ what might be called an “economical” view on studying. Scientific research – from Psychology Today – shows that students have the tendency to study more when the exams get nearer. One could say that the “marginal knowledge-output of learning” is higher when the examination period gets nearer. For now it is irrelevant whether this is due to procrastination on the side of the students, or due to an intrinsic part of human motivation. The fact of the matter is that, when applied to the trimester-structure, this tendency implies that most of students’ studying will take place in the (short) period before the Summer Term. But isn’t this an inefficient usage of both the Michaelmas and Lent Term?

There seems to be an easy way in which the current system could be improved upon (in the light of the aforementioned two arguments). One way would be by moving away from 100% examinations in the Summer Term to – let’s say – 33% exams per term. Another option might be to keep the 100% examination structure in place, but simply create more courses that take up one term only, and test these after the respective term. Besides being optimal from an economic perspective, since students will be studying “at full capacity” all the time, these options would drastically shorten the feedback-period between the absorption of new material and the testing of it, therefore being beneficial from a didactic point of view as well.

In conclusion, it might be worthwhile to take a look at these, and likewise options, to improve upon the educational structure currently applied by many universities in the United Kingdom.

Why Fear is More Efficient than Love

Machiavelli is the father of pragmatic reign: the father of the ‘I’ll do no matter what it takes to stay in power’ mentality sovereigns should, according to Machiavelli, have. You can say what you want about his thoughts, but they sure as hell have been influential. At least influential enough for us to be still talking about them, five centuries after his dead.

I want to focus at Machiavelli’s idea that – for a sovereign – it is better to be feared than to be loved. Machiavelli claims this because he believes that people are ungrateful and unable to be trusted; at least, not for long periods of time. Not until they get hungry again and breaking promises seems to be a better option than starving to death. But I want to focus on a different reason for why a sovereign should try to be feared instead of loved. And that is the simple fact that being feared costs less money – and effort – than being loved.

Being loved requires a constant level of investment from the sovereign; if the sovereign, for example, want to be seen as a generous man, he needs to keep on being generous at every opportunity to be generous that will arise. Giving a poor man money is generous, but to stop giving the poor man money falsifies the generosity of the sovereign. And the same goes for being friendly: if a sovereign wants to be perceived as a friendly man, he needs to be friendly all the time. One moment of unfriendliness means the end of his friendly appearance. Being good is simply a much more difficult role to play than being bad. Why? Because people have the tendency to remember someone’s unfriendly or betraying actions better than one’s well-intended or friendly actions.

Fear, compared to love, requires much less investment from the sovereign. That is because fear is based on expectations: someone’s anxiety from what might be about to come. And it is this sense of what is about to come that can be relatively easily manipulated by means of threats; by promising that something bad will happen if the citizens aren’t loyal to their sovereign. And the degree in which citizens are susceptible to the sovereign’s threats, depends in turn on the credibility of these threats. If the citizens don’t believe that the sovereign can live up to his evil promises, the threats will vanish without having had any effects. Thus the sovereign has to make sure that his threats are credible.

He can do this by means of military forces. If so, he must make sure that his army is bigger in size than – or at least equal to – the armed forces of the citizens – which is easy to achieve by making sure that the citizens are unable to get armory: by monopolizing the production – or at least distribution – of armory. This requires a one-time investment from the sovereign. An investment that – in the long run – will yield more benefits than the everlasting demand to feed the poor.

So although romantic movies might want us to believe that love conquers hate, hate – in the form of fear – might turn out to be the cheapest way to go.

But what do you think?