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The Grey Market Hypothesis

One of the most endearing (and at times frustrating) qualities of children is their natural inquisitiveness and seemingly endless ability to ask question…after question…after question.  It makes sense, as at such a young age our world views and opinions are largely undeveloped.

But the older we get, the more we become conditioned to think in very rigid terms.  A large component of this is our own evolution as our brains are hard-wired to rely on heuristics, or mental shortcuts, that allow for more decisive action and faster problem solving.  A second contributing factor is the structure of our education system which is grounded in testing on questions with definitive answers.  Multiple choice, true or false, yes or no, black or white, right or wrong – and nothing in between.

Shane Parrish over at the Farnam Street blog nails this subject in his recent post The Value of Grey Thinking:

But a major symptom of this style of learning, combined with our natural proclivity to land on easily digestible answers, is that we start thinking in rigid categories: War is good. War is bad. Capitalism is good. Capitalism is bad. America is Socialist. America is a Free Market System. We must support our troops. College is useless. College is indispensable.

And so on. These slogans become substitutes for actual understanding, and it’s not as benign as it seems. The slogan isn’t just a shorthand: It replaces thinking for many people, because it’s hard to generate real understanding. As discussed in the Eager to be Wrong piece, it’s a lot easier to land somewhere simple and stay there. It requires less energy.

But the fact is, reality is all grey area. All of it. There are very few black and white answers and no solutions without second-order consequences.

You can draw a number of comparisons between our diminished capacity to allow for “grey thinking” and the world of investing.  Just think about the UK shocking the world last week with their “leave” vote winning the referendum to leave the European Union.  Good luck finding an ex-post “hot take” that falls anywhere in between this being the next Lehman Brothers type moment or just another opportunity to “buy the dip”.  There is no room for balance and nuance when volatility and emotions are riding high.

Brexit talk aside, I can think of no better corollary to the concept of Grey Thinking than the ongoing – and neverending – debate on Market Efficiency.  Just three years ago, you had two men share the Nobel Prize in Economics for their diametrically opposed bodies of work on the topic.  In one corner, you had Professor Eugene Fama, the father of the Efficient Market Hypothesis (EMH) and in the other, Yale University’s Professor Robert Shiller who is known for his research on market “bubbles” driven by investor irrationality and exuberance.

The contributions of both of these men to the field of finance cannot be overstated.  But the fact that we have yet to reconcile the two sides several decades after their seminal works were published shows how far from cut-and-dried this issue really is.  I was never able to articulate this grey area in markets until I came across one of the better investing books i’ve read in the past few years, Efficiently Inefficient.  Written by Lasse Pedersen, a Principal at AQR Capital Management and finance professor at NYU’s Stern School of Business, it is a tour de force of the world of active investment, market efficiency and the drivers of risk and return. In an article written for Institutional Investor, Lasse summarizes the major theme of his book:

Efficiently inefficient is the real world, it is the one in which investors live day to day. A world where competition within the investment profession results in markets that are almost efficient, but certain inefficiencies exist that may reward those for selectively taking risk and absorbing the associated costs of doing so.

The debate is heated because the answer is very important for investors and society at large. If markets really are efficient, then all investors should choose passive investing. Why? Because passive investing saves on costs, and you can’t beat an efficient market. If, on the other hand, the market is largely inefficient, then investors can extract profits via the pursuit of active investing while society is plagued by the harmful effects of asset bubbles and crashes.

The truth lies somewhere in between: Markets are neither perfectly efficient nor grossly inefficient. But the degree of inefficiency doesn’t just lie somewhere on that continuum. Markets are, in fact, efficiently inefficient. To appreciate this idea and how it can help you attempt to beat the market, it is worthwhile to put into context the two extreme views.

First, the market cannot be fully efficient, as Fama would have us believe, because if it were, no one would have an incentive to be active, so who would make the market efficient? Further, given the billions of dollars paid in active management fees, logic tells us that it is impossible that both securities markets and asset management markets are perfectly efficient. If the securities markets are perfectly efficient, then it is inefficient to pay active managers.

Second, the market also cannot be highly inefficient, completely divorced from economic fundamentals. Why? Because many highly competitive investors try to beat the market, and their attempts to buy low and sell high tend to push prices toward fair value. As anyone who has tried beating the market knows well, success here is very difficult.

The arguments made by both camps described above extend far beyond whether or not to take an “active” or “passive” approach to investing.  Even commonly accepted styles like Value investing aren’t safe.  There is plenty of historical evidence supporting the idea that over long enough periods of time, cheap assets tend to outperform their more expensive counterparts – i.e. the Value Premium.  Yet you can have two different people in full agreement over the efficacy of the Value premium, but at complete odds as to why it exists.  The EMH disciples will call it a risk story whereas the Behaviorists will point to systematic mispricing due to common investor biases.  It reminds me much of the classic Miller Lite ads from the 80’s:

(Personally, I think any style or factor for which you can make a strong case for both a risk premium AND a behavioral anomaly only strengthens its case as a reliable source of long-term returns. But I digress…)

An investor’s belief, or lack thereof, in efficient markets will likely have more influence on their overall investment philosophy than anything else.  It may lead you to index, tilt towards certain factors, hire active fund managers, make regular tactical allocation bets or any other assortment of investment decisions.  But it is not a binary decision.  None of us are forced to choose between one side of the pendulum or the other.  There is room for a middle ground.  You can believe markets are somewhat efficient but invest as though they are perfectly so if you feel strongly that approach will give you the best odds of success.  On the flipside, you might think the market is nuts and will stop at nothing to avoid its wild mood swings. 

Regardless of approach taken, there are lessons we can all take away from the messy grey:

  • Appreciate the difficulties and challenges associated with trying to earn outsized returns. Absent conviction, discipline and a truly long-term mindset, the odds are not in your favor.
  • Markets can act nuts sometimes, but to quote Meir Statman “The market may be crazy, but that doesn’t make you a psychiatrist.”
  • You will always be fighting an uphill battle if you don’t control costs, taxes, turnover and your own behavior.

Investing, such as life, isn’t black and white.  Discover your own path and embrace the grey.

The Value of Grey Thinking (Farnam Street)

Efficiently Inefficient by Lasse Pedersen (Amazon)

Are Markets Efficient or Irrational? Actually, a Bit of Both (Institutional Investor)

About the author

Phil Huber, CFA, CFP®

Phil is the Head of Portfolio Solutions for Cliffwater, a leading alternative investment adviser and fund manager. Prior to joining Cliffwater in 2024, Phil was the Chief Investment Officer for Savant Wealth Management, a multi-billion dollar wealth management firm. Phil has been involved in the financial services industry since 2007. He earned a bachelor’s degree in finance from the Kelley School of Business at Indiana University. He is a member of the CFA Society of Chicago. More about me here. Twitter: @bpsandpieces

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