Neglecting Equilibrium
A new paper shows that most investors don't believe in efficient markets
Markets are made by people. So to understand how and why markets move, we need to understand the subjective beliefs of market participants.
A group of European academics—Peter Andre, Philipp Schirmer, and Johannes Wohlfart—recently completed a survey of 11,000 investors, including retail investors, financial advisors, fund managers, and academics. They found that most investors don’t think about markets the same way academics do.
The biggest difference between an academic view of markets and the view of actual investors is that most investors believe that higher future earnings growth means higher future stock returns, whereas academics believe this information is priced in by an efficient market.
The survey featured a set of hypothetical scenarios, where investors had to predict expected returns based on stale, four-week-old news about a company. For example, they might have had to predict whether Nike’s stock would do better based on old news that Nike had maintained a supplier partnership (neutral) or secured a cost-saving partnership (positive).
From an academic perspective, this old news should be irrelevant to predicting expected returns because the news is old and therefore should have already been priced in. But that’s not how survey respondents answered. While between 67% and 76% of academics expressed a belief in efficient markets, arguing that the news had no impact on expected returns, somewhere between 45% and 81% of investors believed that expected returns were higher in the event of good news and lower in the case of bad news.
Figure 1: Return Expectations Across Samples
Source: Andre et al.
To better understand these responses, the researchers asked open-ended questions about their logic. A typical academic response, they found, would be “the effect on future profits and dividends should already be reflected in the current price.” But most investors responded saying something like, “Based on the—so far—available information I would expect that lower production cost should lead to higher earnings on company side and as such increase total return of the investment.”
The researchers coded these responses as shown below. The efficient markets argument was a popular rationale among academics, but “equilibrium neglect” (the belief that good news, even if old good news, should lead to higher returns and bad news, even if stale, should lead to lower future returns) was the dominant paradigm among all other groups.
Figure 2: Reasoning Underlying Return Forecasts
Source: Andre et al.
If most investors don’t think like academics, this has important implications for asset pricing. “The neglect of equilibrium pricing predicts households’ tendency to form extrapolative and pro-cyclical return expectations,” they write. “Similarly, it may contribute to agents’ tendencies to trade on stale news or to believe that monitoring companies is central to successful stock investment.”
Debuting amid the AI hype, this paper calls for some introspection. Are buyers of these stocks neglecting equilibrium pricing and efficient markets, fueling a classic bubble? Or is the surging pricing accurately forecasting a dramatic change in our economy?