Want proof that the ASX 200 isn't always efficient? Here it is

Warren Buffett doesn't assume the stock market is perfect, and neither should you.

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If you study finance at university, you'll inevitably come across Nodel prize-winner Harry Markowitz's 'modern portfolio theory'. This posits that the stock market, including the S&P/ASX 200 Index (ASX: XJO) is always efficient. Therefore, it is almost impossible for an individual stock picker to outperform it. 

While this theory is taught as something akin to Gospel truth, I think slavishly adhering to it can be a costly mistake for many investors.

How modern portfolio theory works

The idea is that because the stock market is a liquid institution, investors are always able to respond to every piece of available data in real-time. This means that the stock exchange functions as a flawless market, always assigning a share its perfect and indisputable valuation. As such, there is never any differentiation between price and value. Everything is always worth exactly what the market prices it at any given moment.

That makes it, as the theory goes, impossible to beat the market over a long period of time. You can't beat a mechanism that is always completely efficient at finding value, after all. The fact that many investors, such as the legendary Warre Buffett, can and do beat the market regularly, is put down to a lucky fluke.

But I personally think that modern portfolio theory is inherently flawed. While the markets act rationally most of the time, there are periods when it is obvious that investors are acting out of emotion rather than cold logic. If someone is selling their shares because they are terrified of losing their (or their clients') money, they are clearly not reacting rationally to promote an efficient market.

The stock market's history is littered with examples of this dynamic playing out. But there's a recent example that I think perfectly highlights how emotions rather than rationality can govern an investor's decision-making process.

The Endeavour share price is a perfect example

Look carefully at the Endeavour Group Ltd (ASX: EDV) share price below:

Created with Highcharts 11.4.3Endeavour Group PriceZoom1M3M6MYTD1Y5Y10YALLwww.fool.com.au

You might notice the prominent dip that Endeavour shares endured on Monday 17 July.

On that day, Endeavour was rocked by an announcement from the Victorian government, which revealed new gaming and hospitality regulations. These included a reduction in load-up limits for poker machines, down from $1,000 to $100. As well as a ban on non-casino pokies being run between 4 am and 10 am.

ASX 200 investors were savage in their reaction to this news. Endeavour shares closed down by almost 10% that day, falling from $6.26 to $5.64 a share.

Ok, so you might assume that the hyper-efficient stock market was reacting to this new information and adjusting the value of Endeavour shares down accordingly. That theory holds water (thus far).

However, what is more difficult to square is the rapid rebound in the Endeavour share price. Despite no fresh news or developments out from either Endeavour or the Victorian government, by the Friday of that week (four trading days after), the Endeavour share price had convincingly rebounded by 7.3% to close at $6.05 a share. That was just 3.35% lower than the original pre-announcement price.

By the following Thursday, Endeavour was almost back to its Friday 14 July share price, having finished that trading day at $6.18 a share.

Price and value on the ASX 200

In my view, there is no rational explanation for Endeavour's rollercoaster between 14 July and 27 July. How can modern portfolio theory explain the multiple kneejerk reactions investors had over those two weeks? I don't think it can.

I think this alternative explanation makes more sense: investors panicked when the regulation news became public and then collectively hit the sell button. Then, it became clear this was an overreaction and Endeavour's share price has clearly decoupled from its valuation. As such, they subsequently piled back in, bringing Endeavour's share price back to almost where it started.

Considering this one example alone, I think it's reasonable to conclude that the markets are certainly not always rational. If we take that assumption, we can only conclude that it is indeed possible to beat the market by exploiting its occasional irrationality.

So think twice whenever you hear someone talking about modern portfolio theory and how it makes ASX 200 stock picking redundant. I'm sure you can find another example of the markets serving up an obvious disconnect between price and value. As Warren Buffett once said, "price is what you pay, value is what you get".

 

Motley Fool contributor Sebastian Bowen has positions in Berkshire Hathaway and Endeavour Group. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Berkshire Hathaway. The Motley Fool Australia has recommended Berkshire Hathaway. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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