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Efficient market theory? What did the experts miss with Brexit?

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For many years, professors of finance have taught their students that the financial markets largely reflect all available and relevant information. These academics view the markets as the best available forecasting tool, reflecting the combined knowledge of many thousands of investors.

Essentially, they’re saying that the combined wisdom of the group must be greater than that of any particular individual or group. But if this “Efficient Market Theory” were true, any news affecting market prices could not be predictable to the investment community.

What’s more, we’re not sure how to square this theory with recent market behavior in the lead up to and aftermath of the recent British referendum to leave the European Union.

In the days before the Brexit vote, the value of the pound sterling surged, and trading in the stock and bond markets indicated that investors around the globe were counting on the “remain” vote to prevail. According to the New York Times, some of the best-regarded hedge fund managers were expressing great confidence that Britain would stay in the European Union, almost to the point of assuming that that outcome was a foregone conclusion.

If the markets are so efficient, why was the Brexit vote’s actual result so unforeseen?

And, while betting parlors in Britain are hardly a traditional financial market, they made an active book on the referendum; and bookies set the odds solidly in favor of “remain.” Yet, despite those confident market forecasts, we all now know that the vote went the other way.

How is it possible that so many people with real money on the line got this wrong? Highly paid political consultants had ample opportunity to apply their sophisticated algorithms to the polling data. Newscasters, websites and political bloggers produced an almost endless stream of analysis about the election. Even though the oddsmakers favored the “remain” outcome, more individual bets were placed on the “leave” side.

If the markets are so efficient, why was the vote’s actual result so unforeseen?

We believe the reason lies in investor biases. The Efficient Market Theory assumes that the various ill-informed prejudices held by market participants will essentially cancel one another out. In the real world, however, such biases are not randomly distributed. The sphere of institutional money management is a fairly narrow one, with most of its professionals sharing a common type of educational background and a similar worldview. These people also share many of the same information sources; and, believe us, they tend to talk with one another a lot…reinforcing their own shared opinions. In the case of Brexit, investors drew great confidence from the oddsmakers, while the betting public may have been looking at the financial markets for support.

Each side reinforced the other, despite increasing evidence to the contrary. In our minds, this was the equivalent of the so- called “big money” on Wall Street moving stock prices around. The more that those with the biggest bankrolls share the same biases, the more the market prices will reflect these preconceived notions…even if they are wrong.

This is why we try so hard to remove such biases from our own investment process. The more we make decisions based on reality and facts, the more we can try to avoid the all-too-common pitfall of groupthink. This does not mean that one should take a constant contrarian approach, however, since the so-called “smart money” can also be right. In fact, the smart-money people often are correct.

We believe in maintaining a disciplined, long-term strategy, even when that strategy goes against conventional wisdom and short-term trends.

This article is not intended as investment, legal, accounting or tax advice. Any opinions, recommendations or indications of past performance contained in this article may be subject to risks and uncertainties beyond the control of Hallmark Capital Management, Inc. (Hallmark) and are no guarantee of future returns. Hallmark does not guarantee or certify the accuracy, completeness, or timeliness of the information presented in this article. Hallmark is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration with the SEC does not imply that Hallmark or any individual providing investment advisory services on behalf of Hallmark possesses a certain level of skill or training. © Hallmark Capital Management, Inc. All rights reserved.

This article was originally published in the October/November 2016 issue of Worth.

Investing and the Economy

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