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.

However, anticipating future information and consistently earning above-average returns is no easy feat, and requires extensive research and expertise in the financial industry. Wealth management firms, with their team of experienced investment professionals, can provide individuals with the necessary tools and knowledge to make informed investment decisions. By partnering with a trusted firm, individuals can learn more about Vigilant Wealth Management and how their investment strategies align with their personal goals and risk tolerance. While the EMH may hold in theory, the reality of the financial market is much more complex, and it is important to have a skilled team on your side to navigate it effectively.

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.

Financial Markets: Keeping Up the Illusion of Confidence

Financial markets are trading grounds on which not products but ‘packets of confidence‘ are exchanged. Do you dare to face the uncertainty, or do you rather pass the opportunity to some guy more manly than you? Who is the 21th century knight, galloping over the battlefield of fallen companies, always leaving just in time not to get hit by the sweeping sword of bankruptcy, but just long enough to receive the fortune and fame? Who has got the balls to take the risk? That’s the question.

A financial market is a special market. In contrast to ‘normal’ markets – markets at which tangible goods like tables or computers are traded, or services like car-washing and theater – this market is build on top of confidence, or at least the perception of it. Surely, through such things as valuation techniques, financial considerations play a more than average role in deciding whether or not to buy stocks, derivatives, obligations or other financial products. However, just as it is in science, there is always a leap of faith required to take the final step: no matter whether it is in jumping to the conclusion on the basis of data, or making the purchase of a stock based upon a ‘reasonable’ level of confidence. No absolute truths and absolute values exist.

Thus – given that confidence plays such an important role in financial markets – you might expect that regulators overseeing these markets will try to do anything in order to keep this fragile little entity up and running. Just like a friend might gloze over the truth in order to keep you – and therefore himself – happy, so a regulator might tell investors that everything is going according to plan; that there’s nothing to worry about. And although lying might be immoral – according to Kant’s Categorical Imperative at least – that’s exactly what he (the regulator) should do, right? If not, the whole house of cards will collapse; investors become (more) insecure and run away as fast as they can. So you need a Santa Claus kind of figure; someone who, above all, should be trustworthy; someone who, no matter how naughty you have been, will always be there to comfort you. Of course: it wouldn’t mind if he or she would have at least some understanding of financial markets, but that’s just only a bonus (you get it? That was a joke).

So, what would happen if, instead of Santa Claus, you would put a politician in charge of regulating the financial markets? A guy like, let’s say, Jeroen Dijsselbloem? A guy who says that, ‘If the banks can’t do it, then we’ll talk to their shareholders and bondholders, we’ll ask them to contribute in recapitalising the bank, and – if necessary – the uninsured deposit holders.’ Then shit is getting messy, right? The insecure investors, longing for a pat on the back, or at least a little sympathy, start running; like Forrest Gump, the investors get the sign to ‘Run, investors, run!’

Honesty is not appreciated in financial markets, so don’t even try it. Lie as hard as you can. Do everything to keep the rat-race going. Do all that is required to ‘restore the confidence in the financial markets‘; be the 21st century Machiavelli. Don’t listen to the crowd yelling that the banks must bleed for their sins. Just assure that they – the crowd – will get their money back. Illusion leads to confidence, and confidence is king. So lie as hard as you can mister regulators; Go for it!

But what do you think?