The search is on to find a replacement to efficient market hypothesis. Efficient market hypothesis in its strongest form indicates that the current price of an asset fully reflects all the available information about the asset. The theory came with 2 fundamental conclusions which have shaped the investment industry as it is today. The conclusion that the equities in the long run tend to outperform bonds and the conclusion that investors are generally rational and tend not to fall into patterns.

Let us take the first one. Data is now coming out to prove that equities in the last 40 years have yielded less than bonds. The only saving grace is dividends. Once the dividend is added equities have slight edge over bonds (for all the risks). May be we should take this conclusion with a pinch of salt as it is not fair to compare returns from equities in this market. (DOW 7800). But the point here is the idea that we should invest regularly in equities through the ups and the downs and that we should close our eyes to market vagaries, is dead.

“It supposedly didn’t matter how long you waited. But the notion that the long run will bail you out no matter what stupid things you do in the short run I think is dead,”

Second conclusion is proved wrong too. Investors are anything but rational if we see the market volatility in the last 18 months.

“In place of the standard assumption that all decisions are rational, behavioural economists began substituting findings from experimental psychology on how people actually make decisions.Efficient-markets theorists themselves moved away from the hardest version of the theory”.

“And the notion that if you have the better asset class it doesn’t matter what you pay for it is on its deathbed.”

The new theory that is gathering momentum is adaptive markets hypothesis.

“Periods of extraordinary prosperity have behavioural effects – it gives us a false sense of security and therefore there is too much risk-taking. Eventually that kind of risk-taking is unsustainable and you get a burst of the bubble.”

My take away from this article is that the investment management industry; the Hedge Funds, Mutual funds, Wealth Mgmt & advisory will go through a radical change. They have to answer to some tough questions about the blind faith in long term returns of the stocks Vs bonds and about their investment fees.