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Why the stock exchange is not always efficient and how investors can benefit from it – ARTS column

The question of whether active investing is superior to passive investing has dominated the discussion in the financial sector for years. Passionate investors criticize active fund managers for the fact that they rarely manage to beat the benchmark of their funds. However, active funds still make up the bulk of the world’s assets under management. So you are still in the favor of investors.

Stock market drops as we have seen this year reveal the Achilles’ verse of passive investing. Because an ETF can only develop as well or badly as the market. Anyone who has invested their money in ETFs may have to cope with long dry spells until the ETF in question has made up for the loss caused by the stock market crash. For example, the EuroStoxx50 index lost 67 percent of its value in 2000 after the dotcom bubble burst, but even 20 years later the slump has not yet fully recovered.

The theory of efficient markets

In 1970, the American economist Eugene F. Fama published his market efficiency hypothesis, according to which the stock exchange comes very close to an efficient market because it is transparent and information is processed in prices in seconds. The information can be historical data, public information, or even inside information. According to this theory, excess returns cannot be achieved through active fund management, as no one can be smarter than the market.

The irrational investor

The behavioral finance research branch has shaken the theory of efficient markets and the notion of the Homo Oeconomicus. Above all, the basic assumption that people perceive and process information in a completely rational manner is questioned. Rather, behavioral economics has shown that the human investor is subject to systematic misjudgments. For example, the herd instinct leads investors to orientate themselves towards the behavior of other investors or financial experts, which can then lead to under- or over-valuation on the stock markets. Selective perception in turn means that we understand information individually: The information that fits the existing opinion is most likely to be taken into account.

Active momentum trading: exploiting market anomaly from short-term trends

With their research paper “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” from 1993, Narasimhan Jegadeesh and Sheridan Titman demonstrated the momentum effect. This is because stocks that have risen the most in the past have a tendency to continue rising in the near future in a time frame of three to twelve months. One of the researchers’ explanatory approaches is that market participants react more strongly to long-term company news than to short-term news such as profit forecasts.

Neither markets nor human fund managers are rational

The momentum effect has also been empirically proven by other researchers. Behavioral finance explains this market anomaly with an under- or overreaction of the market participants, which in turn should have psychological causes. In the case of the underreaction, the market participants react with a delay to changed fundamental data of the companies, which triggers a longer adjustment process and trend on the markets. A possible psychological explanation for this market anomaly is the disposition effect: This describes the tendency of investors to hold stocks that have increased in value too short and stocks that have lost value for too long. The disposition effect is in turn attributable to the loss aversion of investors who feel losses twice as much as profits. The overreaction in the markets, i.e. the excessive buying or selling of shares in relation to the actual fundamentals, is in turn explained, among other things, by the overconfidence bias, in which investors overestimate their own abilities as investors.

With behavioral finance, empirical economic research has shown why markets are not efficient, which is due to the fact that information processing by market participants is not entirely rational. The momentum strategy enables investors to identify short to medium-term price trends and thus the best temporary entry opportunities on the stock market. As a result of the quantitative approach, emotions are excluded when investing. This also distinguishes the quantitative momentum strategist from the active fundamentally-oriented fund manager: While the latter also suffers from cognitive distortions and only has a limited part of the market in mind, the momentum strategist orients himself solely on the price movements of the markets. In the event of a stock market crash, the momentum strategist can systematically secure the portfolio with a flexible equity quota.

About the author: Leo Willert is the founder and Head of Trading at ARTS Asset Management.

Disclaimer: The text is a column of the ARTS Asset Management. The content of the column is not the responsibility of 4investors and therefore does not necessarily have to agree with the opinion of the 4investors editorial team. Any liability and claims are therefore expressly excluded by 4investors!

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