Friday, February 08, 2013

In defense of the EMH


The "Efficient Markets Hypothesis" is a popular target of anger and derision among lay critics of the econ profession. How can financial markets be "efficient" when they just crashed and took our economy down with them? And when sensible people like Bob Shiller, Nouriel Roubini, Bill McBride, et al. were screaming their heads off about a housing bubble years before the pop?

Of course I have some sympathy for these complaints. But the more I learn about and teach finance, the more I learn what an important and useful idea the "EMH" in fact is. I don't want to say that the EMH is unfairly maligned, but I do think that its vast usefulness is usually ignored in the press.

First of all, people should realize that the EMH is misnamed - it's not really a hypothesis, it's not about "efficiency" in the economic sense of the word, and it's not unique (so it shouldn't have a "the" in front of it). Some of this miswording was just semantic clumsiness on the part of the people who came up with the theory. Some was sloppy science.

The "efficient" part of "EMH" doesn't mean that financial markets lead to a Pareto-efficient outcome. You could have externalities - for example, every time you make a financial transaction, God might kill a kitten - and the market could still be "efficient" in the way that financial economists use the term. Similarly, a vastly "inefficient" financial market might be Pareto efficient, since it might only be possible to make profits by taking advantage of someone else's stupidity.

The "efficient" actually just refers to information-processing efficiency. What that basically means is that if there's some piece of information out there - some fact about a company's balance sheets, or some pattern in past prices, etc. - the market price should reflect that piece of information. That's what "efficient" means here.

But exactly how should prices reflect information? Here's the bigger problem with the term "EMH" (the "sloppy science" part) - it's not really a hypothesis. How prices reflect information will always depend on people's preferences. In finance, preferences include preferences about risk. So without a measure of risk, it's impossible to scientifically test whether or not prices incorporate information. To be a real hypothesis, the EMH needs to be paired with a specification of risk (or, more generally, a hypothesis about people's preferences with respect to uncertainty and time, and a hypothesis about the sources of risk). And since there are many possible such specifications, there isn't just one "EMH"...there are infinite.

To complicate things, "the EMH" says nothing about how long it takes for the market to process information. So even if an EMH happens to be true at one frequency (say, daily), it might not be true at the 1-second frequency.

OK, so is even one of these EMHs true, at some frequency? We can do statistical tests, but we'll never really know. First of all, our tests are all pretty weak. But more importantly, conditions may change! An EMH might be true for a while, and we might conclude it's true, and then things might change and for one or two years it might stop being true, and then we'd do some more statistical tests and say "Oh wait, I guess it's not true after all!", and then it might go right back to being true! We generally assume the laws of physics don't change from year to year, but it's easy to imagine that the "laws" of finance aren't as immutable. What if the market is "efficient" 99% of the time, and the rest of the time there's a catastrophic bubble? 

And to top it all off, theory says that the strong form of the EMH can't even be true.

So "the EMH" is very limited as a scientific hypothesis or physics-like law of nature. And I think that ever since many of these points were pointed out (I think by Andrew Lo, though someone else may have preceded him), financial economists have stopped talking about "the EMH" as such, except in a vague hand-wavey way during informal discussions. Sloppiness has been much reduced.

But I do seem to recall that the title of this post was "In defense of the EMH". So I had better get around to defending it! What I want to defend is the idea behind the EMH. Even if the data rejected every single EMH, the idea would still be incredibly useful for the average person. 

Let's call this idea the Random Markets Idea, or RMI.

The simplest form of the RMI was stated by Paul Samuelson in 1965: "Properly anticipated prices fluctuate randomly." Basically, if it was pretty easy to see where prices were headed, a lot of people would see it, and try to make free money by trading on it. Since people in the finance industry are doing a lot of work - watching the news like a hawk, doing constant analysis of changing numbers - chances are that the price change will happen so fast that you won't have time to get in on the action. So from the perspective of any of us who doesn't have a supercomputer in his head, prices movements must be unpredictable and surprising. They must seem random. 

That's it. That's the RMI. Note that this is very different than saying "On average, people don't beat the market average." This is more than that. This is saying that even if you manage to beat the market average for a year or two years or even ten years, you shouldn't expect to be able to repeat your performance next year. 

That may seem counterintuitive, or even silly. "Hey," you think, "I beat the market last year, so I must be one of the smart guys! And that means I should be able to repeat my performance...right?" Well, maybe. But the RMI says that that's actually very, very unlikely. It's far more likely that you just got lucky.

Now here we get to why the RMI is so useful to you and me and most people (and to the managers of our pension funds and mutual funds). It provides a check on our behavioral biases. Probably the most robust findings in the field of behavioral finance is that individual investors do badly. They are overconfident. They trade too much and take losses on trading costs. They suffer from biases like disposition effect, probability mis-weighting, recency bias, etc. And as a result they lose money, relative to the wise folks who just stick their money in a low-cost diversified portfolio and watch it grow. As for institutional investors - mutual fund managers and pension fund managers - we don't know as much about what they do, but we do know that very few of them manage to consistently beat the market, year after year (and most don't beat the market at all).

It's interesting to note that people usually think of behavioral finance as being an alternative to efficient-markets theory. And sometimes it is! But in the case of personal investing - i.e., the single most important way that you will probably participate financial markets - the two ideas support each other. The RMI says "You can't beat the market"; behavioral finance says "But you're probably going to lose your money trying." 

Of course, even the RMI isn't quite true. There are some people - a very few - who correctly guess price movements, and make money year after year after year (I work with a couple). But you're very unlikely to be one of those people. And your behavioral biases - your self-attribution bias, overconfidence, and optimism - are constantly trying to trick you into thinking you're one of the lucky few, even when you're not. 

The RMI is an antidote to this! Just remind yourself that market movements should be really, really tough to predict. Then, when you start to think "It's so so so obvious, why can't people see AAPL is headed for $900, I'm gonna trade and get rich!", you'll realize that no, it can't be that obvious. And you'll restrain your itchy trigger finger. And when you start to think "My money manager is awesome, he beat the market the last 5 years running, I'll pay his hefty fee and he'll make me rich!", you'll stop and realize that no, it was probably luck. And you'll think about putting your money in index funds, ETFs, and other low-cost products instead.

In general, the RMI focuses your brain on assessing risks instead of trying to outguess the market. This is important, because risk is a difficult thing to think about, while making bets and guesses about returns is relatively easy. But in the real world, most of your portfolio's return will be determined not by how well you make bets and guesses, but by the riskiness of the asset classes in which you choose to invest (stocks, bonds, etc.). Most of the return you get, in the long run, will come from taking risk. But because risk is a cost (imagine if you have an emergency and need to withdraw your money while the market is down!), you need to carefully balance your desire for return with your tolerance of risk. This is what the RMI helps you think about.

OK, let's step back a second. Why do we put our trust in any scientific theory? Well, because it's useful. We know Newton's laws aren't exactly right, but we know they're very useful for landing a rocket on the moon, so when we land rockets on the moon we don't worry about the slight wrongness. And as for our most advanced theories - relativity, quantum mechanics, etc. - well, even those might just be approximations of some more general theory that we just haven't figured out yet. But in the meantime, we use what we've got if it's a good baseline approximation.

The RMI - the general idea behind the various EMHs - is a good baseline for the personal investor (and probably for the pension fund manager too). It works pretty darn well. There are plenty of other areas in which market inefficiency/predictability may matter - financial regulation, corporate compensation, etc. - but you won't typically need to worry about those. You'll be better off treating the market as if it's more-or-less unpredictable and random.


Addendum: It would be unfair not to point out that the RMI is also an important baseline, or jumping-off point, for most financial research. First of all, it leads to the idea that most of the observable factors that explain stock returns should be things that move many stocks at once (and thus can't be diversified). Second, it helped motivate the "limits to arbitrage" literature - if predictable market movements are due to "the market staying inefficient longer than you can stay solvent" (as a famous hedge fund manager-turned-economist once put it), that tells us that when we see things like bubbles, we should look for reasons why "smart money" investors like hedge funds can't stay solvent. Third, the RMI focused financial economists themselves on explaining risk. That has led to the observation and investigation of interesting phenomena like fat-tailed returns, clustered volatility, tail dependence, etc. Fourth, the fact that it's hard to beat the market raises the important question of why so many people try (and why so many people trick themselves into thinking they did, when they didn't). That investigation has led to much of behavioral finance itself.

In other words, in science as in your personal investing life, the RMI serves as the fundamental baseline or jumping-off point. That doesn't mean it's the destination or the conclusion of financial economics. It isn't. But having a good baseline principle is extremely important in any science. You need to know where to start.


Update: I wasn't going to write about this, but John Aziz in the comments made me unable to resist. What I actually think about the RMI (or "the EMH") is this: At any given moment, there are infinitely many models that describe financial markets better than the RMI. And at any given moment, there are a finite number of available, known models that describe financial markets better than the RMI. But all non-RMI-type models will stop working well shortly after they are discovered. In other words, if you had to pick one model of financial markets and stick to that model for a very long time, the RMI is the best one you could pick. So in some sense, the RMI is the closest you can get in financial markets to an exploitable, stable "law of nature" like the models we use in physics. For people who don't have time or skill to constantly search for new models, the RMI is best. I plan to make this idea the subject of another post in the future.

86 comments:

  1. And as a result they lose money, relative to the wise folks who just stick their money in a low-cost diversified portfolio and watch it grow. As for institutional investors - mutual fund managers and pension fund managers - we don't know as much about what they do, but we do know that very few of them manage to consistently beat the market, year after year (and most don't beat the market at all).

    Next you're going to tell us most of our children aren't above average...

    I agree with all this as investment advice for me personally, but obviously someone out there has to decide based on their information about the market what the price of AAPL ought to be and make trading decisions accordingly if there is to be any information whatsoever incorporated into its price. What fraction of the market has to actually make informed decisions to make it work properly while the rest of us walk around blindfolded, confident that if there were any hundred dollar bills on the sidewalk someone would have picked them up by now?

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    1. Next you're going to tell us most of our children aren't above average...

      Haha in this case it's even worse...only 5% or so are above average! ;-)

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    2. Funny, shortly after writing that I came across this great lecture:

      http://larspsyll.wordpress.com/2013/02/08/on-the-irreversibility-of-time-and-economics/

      which nicely demonstrates why, even without investor stupidity or any differences in investing ability, we should expect pretty much all investors to be below average.

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  2. Markets aren't efficient; they are made efficient. The question you have to ask yourself is whether you are making them efficient or not.

    The other parallel is entrepreneurship. Efficient markets says all businesses that can exist already exist. We know this is false, but we also know the difficulty in creating one and we should consider that it is unlikely we can do so and ask ourselves why we believe we can. Efficient markets are as close as we can come to truth that is false in the limit.

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    1. The question you have to ask yourself is whether you are making them efficient or not.

      Actually that's not true at all! You may make the market more efficient but fail to reap any benefit from doing so. Or you may make the market less efficient but reap big profits (I can think of some people who probably do this!).

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  3. This was very funny: "Of course, even the RMI isn't quite true. There are some people - a very few - who correctly guess price movements, and make money year after year after year (I work with a couple). "

    About 5% of the time, the test comes out significant (not corrected for multiple comparisons).

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    1. Well, actually I was kind of kidding...the people I work with are institutional investors. But there are some individual investors who routinely beat the market. See the Shumway paper:

      http://papers.ssrn.com/sol3/papers.cfm?abstract_id=364000

      As for that 5% cutoff, you can easily make it 1% or 0.1% if you like. The people who did this study (and the others like it) definitely thought of that one. ;-)

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  4. Anonymous11:28 PM

    There may be information in the crowd not located in any individual

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  5. I think the test for the usefulness of EMH as an idea is what you think would be different about the world if the idea didn't exist? What idea would take its place to dominate thinking on market movements? Surely almost any idea could be better than 'prices fluctuate randomly'. Because there are periodic cycles, there are particular characteristics of price movements (shape of the distribution) etc.

    And I guess most people would have a hard time understanding the subtlety between

    "On average, people don't beat the market average."
    and
    "...if you manage to beat the market average for a year or two years or even ten years, you shouldn't expect to be able to repeat your performance next year. "

    My suspicion is that some market player do consistently beat the market average for very long periods of time. Something that would be statistically near impossible without an infinite number of players. I can't imagine there is evidence of tracking all returns to individuals and institutions over a long period of time in all markets. If there is, let me know. But that is the evidence you would need to skip from your first to second statement above.




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    1. there are periodic cycles

      *ALERT ALERT ALERT*

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    2. Periodic is too strong but waves occur.

      Where randomness fails is the extreme frequency of extreme events where one in a million events happen every few years.

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  6. This post should probably be called something along the lines of "Why the Efficient Markets Hypothesis is Fatally Flawed, But Why The Idea Underneath It Is Kinda Useful But Not Entirely Watertight.

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    1. The second part is much more important than the former. And not just "kinda" useful, but incredibly useful.

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  7. "As for institutional investors - mutual fund managers and pension fund managers - we don't know as much about what they do, but we do know that very few of them manage to consistently beat the market, year after year (and most don't beat the market at all)."

    This confuses two issues. (1) do professional investors profit from their trades?, and (2) do real-money investors profit from hiring professionals?

    In the CAPM model, 100% of trading profits should go to labor, 0% to capital, because capital only gets rewarded for systemic risk.

    Empirically, professionals do profit from their trades. And they do charge fees approximately equal to value added. So the answers are (1) yes, and (2) no.

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    1. This confuses two issues. (1) do professional investors profit from their trades?, and (2) do real-money investors profit from hiring professionals?

      Yes, I didn't discuss this issue here.

      Empirically, professionals do profit from their trades.

      Well...maybe. Without assets-under-management fees (i.e. with pure symmetric performance-based fees), the vast majority of the money-management industry would go out of business.

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    2. The key point is, regardless of how inefficient markets are, investors should not be able to make money from it. That's because exploiting market inefficiencies doesn't add any risk to an investors portfolio, hence the return should be zero.

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  8. One another thing - the average person should not regard markets as random. They should regard markets as hostile! Because individual investors systematically lose money on their trades, far in excess of commissions and bid-ask spreads. They aren't just enriching their brokers, they are feeding the market.

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  9. Those guys you work with drew my interest. How can you be sure that they are NOT the ones being lucky? Distinguishing luck from skill is notoriously hard to do... even if you have 15 years of individual performance...

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  10. When it comes to economics...there's a "premise" (our preferences) and a "conclusion" (how society's limited resources are used). Therefore, an inefficient allocation of resources can be thought of as a non sequitur.

    Let's consider a specific example. Clearly I derive some amount of benefit from reading your blog. But I've never even once paid you a penny! Therefore, I'm a free-rider! Ack!

    We can solve this free-rider problem by forcing everybody to pay $10/month to a general blog fund that would be allocated by 500+ elected representatives. Except, how could those representatives possibly know exactly how much I value reading your blog? They can't. This is known as the preference revelation problem.

    I'm the only one who knows exactly how much value I derive from reading your blog. Yup. It's a fact that I'm the only one who knows my true preferences. And you're the only one who knows your true preferences! And if the conclusion really does not follow from the premise...then we have a non sequitur.

    So if I had to pay $10/month anyways, then why would I lie about my preference/demand for your blog?

    You've heard the common expression..."like a kid in a candy store". It would match my preferences if you were to write a blog entry about that concept. Really really think about it. It's the complete opposite of a non sequitur. Life, for each and every one of us, should be the complete opposite of a non sequitur. Does that match your preferences? If you really want life to be jam packed with things that really match your preferences, then you have to have the freedom to spend your limited time/money on the things that most closely match your preferences.

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  11. My favorite EMH example is picking lines at the supermarket. In a sufficiently liquid market (e.g. lines at every register, good sight lines) it is safe to assume that you can't save time by actively picking lines. This example has lots of educational potential: insider information, the cost of gathering information, the ability to beat the market by having more accurate models.

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    1. If you are a regular, more so than most, the inside information is what checker is fastest, something the casual shopper won't know.

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    2. I try to avoid the line where the people in line look stupid.

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    3. Yes, the supermarket line is my favourite too.
      It’s also fun to take that model to the extreme—let’s assume everyone believes in complete market efficiency so no one bothers to look for a short line. Result—inefficiency / mis pricing and short queue opportunities.
      We know that few active managers beat markets consistently—though a large part of this is due to so many of them hugging the index. Clearly they cannot outperform after being cropped with charges. So if you buy active - don't buy closet trackers.
      And i think passive investors should be aware of two facts. They cannot beat the market.
      They need a vibrant active management industry to keep the queues even.
      So if you think EMH and passive investing is so great - best to keep it a secret - ooops too late.

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    4. Has anyone done empirical test on supermarkets? My experience from a number of European countries is that you can save ~50% of queueing time if you just look.

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    5. For the whole story read: http://agoraphilia.blogspot.ca/2005/03/doing-lines.html

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  12. Of course the reason why we think Newton is useful is that we know pretty well when it's valid and when it's not, so we know which questions we can answer using Newton. The big problem of the EMH is that it does not come with this crucial constraint of validity. And quite a few economists use it far out of its obvious bounds, and use it as a fixed truth, which leads them to absurd conclusions. I think you know what I'm talking about. So it's not an EMH itself that's problematic, it's about the way it is used. When a physicist nowadays uses Newton to show that an atom can never be stable, he will be (deservedly) derided. If only that were true for the use of the EMH in economics.

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    1. I think this is generally right, but what examples were you thinking of? My main example of this would be option pricing theory and the idea of "implied volatility surfaces", which I think doesn't really benefit anyone. But what did you have in mind?

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    2. Phil Koop8:49 PM

      'My main example of this would be option pricing theory and the idea of "implied volatility surfaces", which I think doesn't really benefit anyone.'

      In all of this post and your subsequent comments, this is the only claim that opened my eyes. Why do you think this? It's easy to see that implied vol doesn't really mean anything - it's just a convenient tool for representing and interpolating prices. But by that very token - it's an entirely pragmatic construction - it seems contradictory to claim that it is of no benefit.

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    3. Well, maybe I should say much about this...

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    4. Phil Koop9:23 AM

      Yes; that might make an interesting post.

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  13. Lulz4l1f37:47 AM

    What do you call the bias where you are so convinced that you cannot beat the market that when you finally get down to value fundamentals and start to consistently beat the market over the medium to long term that you begin to second guess yourself and you begin to diversify to the point you di-worsify?

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    1. So you think you could beat the tabby cat at stock-picking? :)

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    2. Markets can be unpredictable without the formal, original, EMH. Markets can be "even worse" the sense that not only do they aggregate all known information, they also aggregate all known emotion and biases of attention and focus. Entire industries can ignore problems, and it has been documented that prices will coast on happily.

      The EMH just-so story is a comforting tale, but not accurate or complete.

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  14. A problem with your stance - and something I alluded to in the post you link - is that there are a few reasons the market might be hard to beat. It might be because information gets incorporated quickly. It might be because markets are so chaotic. It might be because 'the market can stay irrational longer than you can stay solvent.'

    I'd be interested in a prediction made by the EMH other than 'the market is hard to beat.' It is not unique and in fact could be considered trivial.

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    1. I'd be interested in a prediction made by the EMH other than 'the market is hard to beat.'

      Ah, yes. There is one: Event studies. Look at some piece of identifiable news (e.g. an earnings announcement or court decision), and you'll find that there's generally a large and very rapid jump in the price. That means that information is getting incorporated into prices very rapidly.

      Now, A) there is some "drift" before announcements, and some different-looking drift after. The former is probably due to some kind of insider trading (it turns out that most of it is due to trades by individual, not institutional investors, suggesting insiders). The latter is probably due to momentum, or the "underreaction-overreaction" process, which is not well-understood.

      BUT, the jump right at the time of the news is much bigger in size than the drift, and it's very fast. That means that news moves markets.

      Now, of course, plenty of other stuff besides news could be moving markets too (and probably usually is). But that's beside the point here.

      The point is that you can look and actually observe many, many instances of info get incorporated into prices very quickly.

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    2. Anonymous1:56 PM

      Noah:
      "The point is that you can look and actually observe many, many instances of info get incorporated into prices very quickly."

      Well, yes. Which really says nothing about whether the info is reflected accurately.

      I suppose much of the fury at the EMH is a consequence of it being interpreted as propaganda. Fama, for example, has not been shy in claiming that the EMH implied allocative efficiency. A claim that is simply false. eg Fama(1970)

      "The primary role of the capital market is allocation of ownership of the economy's capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms' activities under the assumption that security prices at any time “fully reflect” all available information. A market in which prices always “fully reflect” available information is called “efficient.”"

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    3. Which really says nothing about whether the info is reflected accurately.

      That's right. It just says that in gets incorporated, however rightly or wrongly, quite quickly.

      Also there's a very subtle question of what "accurately" means...does that mean accurately with respect to the information of the best-informed person? With respect to the total aggregated information available to investors? Or with respect to the unobservable truth?

      I suppose much of the fury at the EMH is a consequence of it being interpreted as propaganda. Fama, for example, has not been shy in claiming that the EMH implied allocative efficiency. A claim that is simply false. eg Fama(1970)

      Correct.

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    4. Herman4:28 PM

      Noah:
      "Also there's a very subtle question of what "accurately" means..."

      Oh, absolutely. Though, I wonder whether Fama & co. saw this ambiguity as a feature or a bug. For propagandists, ambiguity is usually a feature.

      unobservable truth

      "Transcendental Truths" perhaps? ;-)
      Not a a definition of "accurately", but what not a few academic economists, allergic to empiricism, believe in.

      PS:Apologies for the earlier anon post. That was me.

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    5. I'll have to read more history and old Fama papers before I know how much the EMH was oversold in those days. I started doing finance stuff after the behavioral revolution, including all the anomalies literature and the Andrew Lo evolutionary markets stuff, had already come out and been widely accepted.

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    6. Anonymous5:33 PM

      "I'd be interested in a prediction made by the EMH other than 'the market is hard to beat.'

      "Ah, yes. There is one: Event studies. Look at some piece of identifiable news (e.g. an earnings announcement or court decision), and you'll find that there's generally a large and very rapid jump in the price. That means that information is getting incorporated into prices very rapidly."

      But wait, doesn't the recent experience with the collapse of the housing bubble contradict this? In 2006. it was clear to all observers that the housing bubble was over, yet "the market" continued to grow, believing that all was "contained" and that a "Greenspan Put" from Bernanke would make all well again. Only a few market players, like GS, Paulson, later Soros, saw the true implications of the housing bust; the rest of the markets continued to grow through 2007 - recall that the Fed's main concern in 2006 was inflation!

      So, on the one hand, EMH tells you something Grandma knew ('the market is hard to beat'), and on the other, it's flat wrong ('information is getting incorporated into prices very rapidly'). No?

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    7. it's flat wrong ('information is getting incorporated into prices very rapidly')

      No, this isn't what I was saying. We can see examples of news getting incorporated into prices quite rapidly. But we can't easily see examples of information not getting incorporated into prices, because it's impossible to prove a negative. See? Except in a laboratory of course (which is why I do experiments).

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    8. If it's impossible to show that markets don't incorporate information into prices, then this particular idea is not really falsifiable, is it?

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    9. Not formally, no. If known news events were associated with slow increases in price, then the idea is false.

      And actually, a few kinds of news events probably are associated with slow, observable rises in price instead of discontinuous jumps. So the idea is probably false in some cases!

      Here's an interesting idea to ponder: The RMI is always and everywhere massively wrong, in a near-infinite number of ways. However, any one of the ways in which its wrong will vanish shortly after it is discovered. Hence, there exists no model of financial markets that will be durably better than the RMI, even if at any point in time it is nowhere close to the best model. In other words, the RMI is the best "law of nature" to describe financial markets, while all the better models are not at all like laws of nature.

      This is what I believe to be essentially the case. I was thinking of putting that in this post, but I wanted to focus on the behavioral-econ reason for believing in the RMI, not the philosophy-of-science question of "What is a law of nature?".

      What do you think?

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    10. However, any one of the ways in which its wrong will vanish shortly after it is discovered. Hence, there exists no model of financial markets that will be durably better than the RMI, even if at any point in time it is nowhere close to the best model. In other words, the RMI is the best "law of nature" to describe financial markets, while all the better models are not at all like laws of nature.

      Quite hard to assess this in a scientific way. Sounds intuitively satisfying, at least. Makes sense in my gut.

      When I think about what prices actually reflect, I keep coming back to the idea that the thing a current price really reflects is the subjective informational outlook of the two most recent market participants who reached that price (this is a quirk of how we measure stocks from the most recent price, rather than some kind of moving average). True, the pre-existent market will usually have informed that process, although that can be to a lesser or greater degree. Ultimately the human informational ecosystem reflects that humans are somewhat irrational and wild, and RMI reflects this quite well. All kinds of informational traps and feedback loops can form that can push market participants in random directions.

      I was thinking about real world constraints to informational efficiency, and I remember back in 2004 when I could buy an AAPL share for less than $50. I was convinced at the time that AAPL was going to become the biggest computer company in the world, and I would have probably put fair value at maybe $150+ a share, and it turns out I was correct (at least about the first part — the price target is open to interpretation). I was acting on information that was publicly available, but there were always sellers who were operating from a different informational outlook who would sell to me for far less than I was willing to pay. Why? I was liquidity constrained. If I (and others sharing my outlook) could have leveraged up and bought AAPL all the way up to my price target, I would have. But I wasn't a hedge fund, I was a kid with an interest in tech stocks. So I'd say one barrier to true informational efficiency in the real world is liquidity constraints. Stock prices will reflect as much a battle between different worldviews and the respective levels of liquidity behind those worldviews, as we are seeing today in the battle over Herbalife.

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    11. Quite hard to assess this in a scientific way.

      Impossible, actually. You can't do science if the laws keep changing. Imagine if the laws of physics kept changing (according to some meta-law that we couldn't observe). That would be weird.

      All kinds of informational traps and feedback loops can form that can push market participants in random directions.

      Right. The question for the individual investor is whether he wants to be part of that chaos, or stand back from it.

      When I think about what prices actually reflect, I keep coming back to the idea that the thing a current price really reflects is the subjective informational outlook of the two most recent market participants who reached that price

      And their beliefs about other people's quality of information, reasons for trading, rationality, etc.! Remember, anyone who trades should always think about why their counterparty thinks the trade is a good thing.

      But yeah, finance theory is definitely moving toward "heterogeneous beliefs" models, exactly like you're talking about.

      Stock prices will reflect as much a battle between different worldviews and the respective levels of liquidity behind those worldviews

      I think this is right...and the question is, does this make markets more or less volatile? If the liquidity-constrained people are more likely to be poorly informed, overconfident individual investors, then this might be a good thing!

      ...Hmm, I think I'll write that paper. ;-)

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  15. Mark Jamison10:02 AM

    EMH is the product of three conceits. Originally it was a conceit of the Enlightenment regarding the perfectibility of man through rational thought. It has since become a modeling conceit, a simplification of assumptions that make models easier to build and perhaps try to make them appear more predictive then they are. The third conceit is the idea that markets are natural occurrences that exist according to some universal guiding light in the ways that Newton's laws exist.
    Yes, at a basic level markets will form. I have this and you have that and we seek to make a trade. But even at their most basic levels markets exist and function as a result of the societal rules and constraints we place upon them - we describe rules and terms by which we make trades.
    At every level but especially as markets get more complicated the rules we make and enforce determine how efficiently information gets processed and absorbed. The rules determine where the asymmetries are and whether those who seek to create asymmetries are punished or held in check.
    At best EMH is a rather limited tool that helps us discover some aspects about the nature of markets. At worst it becomes a religious dogma, a canon approaching ritual, which becomes an element of the Faith.

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  16. Anonymous11:27 AM

    Oh dear. Finance theory really has nothing left, does it? No longer proudly (albeit delusionally) claiming to know the TRUE PRICES. Just this rather pathetic observation that its hard to predict what people will do. It really is time to wind it all up and get real jobs.

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    1. Oh dear. Finance theory really has nothing left, does it? No longer proudly (albeit delusionally) claiming to know the TRUE PRICES. Just this rather pathetic observation that its hard to predict what people will do.

      No, that's not right at all. In fact it's the opposite of right. The old 1960s theories - EMH + CAPM - basically imply that finance profs can all give up and go home. But since those theories aren't right, it means there's huge research to be done figuring out what really is going on.

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    2. Anonymous7:35 PM

      No, its nothing so rational.

      If your view of the EMH is accepted then there's nothing to figure out in a universal sense- everything is path dependent and you can only understand/explain it in its own specific context. Academic finance should be a form of history.

      But that's the opposite of what happens. Finance theory is still asset pricing, where the search is still on for the ONE TRUE MODEL. Factor models, inter-temporal CAPM, etc , etc.

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    3. If your view of the EMH is accepted then there's nothing to figure out in a universal sense- everything is path dependent and you can only understand/explain it in its own specific context. Academic finance should be a form of history.

      Actually, I'm pretty sure that's not right, mathematically.

      Finance theory is still asset pricing, where the search is still on for the ONE TRUE MODEL. Factor models, inter-temporal CAPM, etc , etc.

      Some people are still searching, yeah. Though it's common to hear that "the asset pricing literature is stuck." But I'd say the majority of people are working on other stuff - banking, institutional stuff, regulation, behavioral, international, game-theory and asymmetric-info, corporate finance, etc.

      And sadly, there is the area of "macro finance", in which crappy DSGE macro models try to invade finance. They must be stopped! Fortunately they all seem to be pretty useless for asset pricing, so I think lots of people are annoyed with this subfield.

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    4. Anonymous7:06 AM

      Well I guess there are two ways of trying to explain the sub-prime crisis, for example.

      Mathematically - in which case you get the statements about 25 standard deviation moves in prices (remember the GS chief risk guy) which people try to fix by curve fitting, really epicycles - stochastic volatility, jump models, etc.

      Or you look at the combination of real things, institutions and event, that came together - securitization, demand for AAA-rated assets, rating agencies, legal structure of the US housing market, interest rates,regulation, incentives, etc, etc - to explain what happened.

      Now of course I agree with the RMH, but only in the sense that Richard Thaler talks about the random wanderings of a drunk. In the case of sub-prime it was not possible to predict when prices would crash and all those guys went broke trying to short the market. The market can be irrational longer than you can stay in the game, and all that. Thats kind of all you're saying and Keynes said it long ago.

      In the end to understand or make sense the sub-prime crisis you need to understand the "physical" combination of causes. That's what I mean by history.

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  17. Noah: this all seems right, but I'm surprised that you of all people don't go on to explain why it is fallacious to argue - as so many who should know better do argue - from efficiency in the sense you have specified to the claim that prices equal fundamental values.

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    1. Oh, well that's certainly true, and I have lots of thoughts about that topic, but it's enough to deserve its own whole post!

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    2. Anonymous1:05 PM

      Kevin quinn is right. If the EMH isn't about efficiency, why do their defendants argue all the time for financial liberalisation and free (financial) markets? Are they making the case for the goodness of random games?

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  18. I'd say that the EMH is holding a place which should be held by a better structure. The place is there. Markets are information rich and fast. There is no guaranteed way to get in front of market information. The price is what it is, and any individuals idea of a better or future price is just an idea. But the EMH especially initially made too-grand promises about what was in the current price and why. If a fair world EMH would have died with "strong" versions of itself, and the clever remarketing to "weak" would not have happened. We'd have another framework.

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  19. I have difficulties understanding how 'the supposedly efficient market can be aggregated into a huge lump and used to draw meaningful conclusions. If one looks at the time constants to reach equilibrium, or the possibilities of ever reaching equilibrium given intervening 'informational' events, the difference between 'flash trading' and say, manufacturing an airliner (sorry Boeing) are several orders of magnitude. Flash trading provides an efficient market for specific purposes that clears in milliseconds, yet it will be literally decades before the wisdom of Boeing's multi-billion dollar Dreamliner gamble in research, hardware and manufacturing technologies can be judged to have been a success or failure.

    It's an old book, but if one wishes to understand long range technological developments, The Sporty Game, about the development of passenger aircraft in the age of deregulation. It was originally published in the 'New Yorker' and is available on line at: http://www.newyorker.com/archive/1982/06/14/1982_06_14_048_TNY_CARDS_000336431

    Essentially, aircraft manufacturers are forced to literally bet the company on the development of a new aircraft, and production costs are dependent on rate of manufacture planned against a very uncertain future.

    The point is, that in 'flash trading', markets can clear almost instantly (unless the software goes wrong) whereas the longer the time it takes to 'clear' the market, the more time there is for interceding changes to influence the outcome, especially the fate of the airline industry customers.

    Thus, for example, on aircraft manufacturing stocks, we're back to Keynes uncertain future stretched over years and decades, and the stock price on a short term basis, has very little to do with the initial success, or lack thereof, of the aircraft, and everything to do with Wall Street speculation.

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  20. Anonymous3:22 PM

    So, if I understand correctly, what most active asset managers are good at is not really at picking winners but at tricking customers into believing that. There is however some sort of wizards who can pick winners at some point but not consistently (the richest person in the world is not a trader)and, like some strange particle, you can identify who they were by their past trajectory but there is no way of knowing who they are now. More than that, those wizards' magic power is not really science but insider info or market power (i.e. not price takers).
    Have I drawn the right conclusions here?

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  21. Andrew7:22 PM

    "No, that's not right at all. In fact it's the opposite of right. The old 1960s theories - EMH + CAPM - basically imply that finance profs can all give up and go home. But since those theories aren't right, it means there's huge research to be done figuring out what really is going on"


    I'm not sure that's quite right.

    Surely the implication is that Finance professors shouldn't go home, but should be shouting from the rooftops that the current system is flawed (i.e. 90% of funds invested in active managers).
    But the majority (Paul Samuelson, Ken French, some others aside) don't do that.

    The vast majority of (even smart) non-professionals do not know that the vast majority of professional active managers subtract value. But EMH-trained economists do.

    So the question is: why do the lessons of EMH not affect the real world, and why do finance professors not educate more on this, but instead spend time looking at minor frictions (small stocks, index distortions etc)? I.e. "ketchup economics" (as Larry Summers once called it).

    It's probably a "political science" answer: that's how you get a PhD approved, and how you get tenure, and it's financial firms which are most likely to contribute to business school funding etc.

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    1. Surely the implication is that Finance professors shouldn't go home, but should be shouting from the rooftops that the current system is flawed (i.e. 90% of funds invested in active managers).
      But the majority (Paul Samuelson, Ken French, some others aside) don't do that.


      Oh yes they do!! The idea that actively managed funds are a bad deal is the biggest cliche among finance professors, and they say it all the time. It is essentially the centerpiece of every intro finance textbook I've ever seen. It is the big empirical success of academic finance. Everyone says it!

      The vast majority of (even smart) non-professionals do not know that the vast majority of professional active managers subtract value. But EMH-trained economists do.

      Correct. This is a big problem. People have tried to fix this (Burton Malkiel's whole career has been dedicated to this), but active managers have big advertising budgets! Even so, note that actively managed funds are managing a smaller percentage of people's money these days, and index funds and ETFs have grown dramatically, so I think progress is being made.

      It's probably a "political science" answer: that's how you get a PhD approved, and how you get tenure, and it's financial firms which are most likely to contribute to business school funding etc.

      That too, though actually most b-school finance area funding comes from big banks who want to hire MBAs, not from the money management industry.

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    2. Anonymous9:39 AM

      "The big empirical success of academic finance" is, ironically, also one of its greatest failures. Measuring "active manager" returns is not meaningful because there's no way to get an active management "signal" from this bunch of investors.

      The average "active" manager runs a portfolio of 150 stocks which is turned over 100% each year. These managers aren't hunting inefficiencies! Cremers and Petajisto demonstrated much the same point in their work which showed that approximately 45% of "active" managers are really closet indexers. The point is that academic finance created this Frankenstein by preaching the virtues of Portfolio Theory. They can't now turn around and claim victory -- all they've done is broken something to the point that it no longer provides a signal!

      There's plenty of empirical evidence in support of the fact that "truly active" managers - those who run concentrated, high "active-share" portfolios, outperform with persistence. Yet most people ignore this empirical evidence because they've been taught that it cannot be true.

      I really applaud your open-minded thinking with respect to EMH. Another way of saying essentially the same thing is this: EMH may be correct in a vague/weak form, unfortunately it is not very helpful in this form. We could say the same for many of the "models" that academic finance has produced. Perhaps (and I know this is antithetical to financial academics) this is a field which just isn't well-described by models? Perhaps the best way to understand an asset and the risks of that asset, is to use human judgement and intuition, to do deep due-diligence. We've never proven this "model" to be flawed (in fact the evidence cited above says exactly the opposite).

      Investors can and do outperform the market consistently over time. Their jobs are made that much easier by the fact that so much money is blindly following the advice of academic finance by investing with closet indexers, ETFs, and index funds.

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  22. Anonymous7:31 PM

    I like the defense. EMH is an immensely useful idea. The only complaint I have with your piece is the assertion that the RMI is somehow the more useful idea. You sort of point it out in the addendum to your piece, but I think wrongly attribute the jumping off point in financial research to RMI. RMI = EMH + a random walk. Really, EMH is much broader in its implications as return predictability is in no way incompatible with EMH. For example, if a shock causes a change in risk aversion, and if risk aversion itself follows a predictable process (which empirical work you mention suggests), returns will look predictable and all information can be efficiently priced. All this just depends on what you've paired with your EMH + [insert pricing model]. RMI is more constrained and has no explanation for such a scenario.

    In response to some of the comments:
    With respect to EMH being overly propagandized, whether you believe it or not, there are really no better current "hypotheses". Lo and others with behavioral explanations have good ideas about the market being a learning, evolving thing. While potentially true (and not necessarily incompatible with EMH), you can't mistake these ideas for a testable hypothesis, which makes them a lot less "useful". Behavioral models prove hard to generalize and don't tend to provide a measure of, or guidance on, how people (in the aggregate) make their consumption/saving decisions.

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    1. The only complaint I have with your piece is the assertion that the RMI is somehow the more useful idea. You sort of point it out in the addendum to your piece, but I think wrongly attribute the jumping off point in financial research to RMI. RMI = EMH + a random walk.

      No, that's not true. The "RMI" I'm talking about is not a concrete theory, just an idea or principle. You can get a good baseline for analyzing financial markets without commit yourself to a specific risk model. In fact, the RMI basically implies that the forecastable parts of returns are probably due to some sort of risk, even if you don't have the complete risk model in front of you.

      Also, you're right about there being no general theory to replace the EMH+CAPM yet. Even factor models are not really there, much less behavioral models. Remember that non-EMH models tend to become less effective as they are disseminated. That's why the RMI is such a powerful idea, even as each EMH is discredited.

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  23. Information about stocks is unreliable and is known to be unreliable. At any given time the price of a stock will be the market clearing price set by investors who have various levels of trust in the information they are receiving. Do anything to reduce the level of trust and you would expect to see prices fall - even if the information does not change.

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    1. Well, information about the reliability of information is also information!

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  24. Phil Koop8:57 PM

    "How prices reflect information will always depend on people's preferences. In finance, preferences include preferences about risk."

    Most of the differences over EMH between economists and finance professionals boil down to this. Economists prefer to regard preferences as stable. And that is quite reasonable: how can you hope to prove or falsify anything if changing preferences are always hanging around as a get out of jail free card?

    But you will never get far in finance if you think this way. To a financial operator, prices are as likely to change because the price of risk changed as because probability estimates changed.

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    1. I am not sure that's right...for example, finance professors often interpret "excess volatility" as a change in discount rates, which is a change in preferences.

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    2. Phil Koop10:37 AM

      Ah! Well, perhaps I'll have to revise my prejudices.

      I have to confess that I know little of this literature. Are you talking about the stuff where stochastic consumption growth rates induce fluctuations in risk aversion even when the utility function is preserved? I thought that still left unexplained volatility anyway.

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    3. There are all kinds of "preference shocks" in these models.

      Not my preferred way to model preference changes, but it is done.

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  25. Anonymous10:35 PM

    Good to know the EMH is no longer considered a defense of the ability of markets to efficiently allocate capital or price risk. A real take away.

    Could we please redo the last 30 years?

    Thanks.

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    1. Haha I'd be taking away almost all of my own life! ;-)

      But yes, the EMH should never be used to imply that the market allocates capital efficiently. I'll write a post about that. But the simple reason is this: Suppose there are people who buy and sell randomly (noise traders). You can't predict what they do. The risk they create is incorporated into prices. They are even being "rational" by following their own weird random preferences. But the market price is never the discounted expected value of future dividends, so it doesn't lead to the efficient allocation of capital.

      And yet, it's still a bad idea to try to "beat the market".

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    2. Anonymous11:43 PM

      I'm more interested in what a weak defense of the weak form says about financial market regulation than what it says about an individual's investment strategies.

      To a more than casual observer, the EMH was used to argue markets allocate capital efficiently, and was a substantial part of the reason the profession failed to address the systemic risk created by financial innovation.

      This makes it an issue for more than just the lay critics of the economics profession, and means it is reasonable to discuss the implications of your conclusions for economic policy, and specifically, financial market regulation.

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    3. To a more than casual observer, the EMH was used to argue markets allocate capital efficiently, and was a substantial part of the reason the profession failed to address the systemic risk created by financial innovation.

      This was all about semantic sloppiness. What defenders of financial innovation and deregulation were really invoking was Pareto, or economic efficiency - the same idea that people use to justify deregulation everywhere. If this got confused with the "efficient" in "EMH", it was because the EMH was sloppily named (and maybe because lobbyists were being disingenuous).

      In fact, I won't go into it deeply, but there is a mathematical argument that says that if markets are informationally inefficient, then that is a reason to deregulate. Here's an intro explanation, in case you're interested:
      http://magic-maths-money.blogspot.com/2012/09/the-fundamental-theory-of-asset-pricing.html

      But see, that piece of finance theory implies that the situations where markets are predictable is the situation where you need to allow more financial innovation (more "complete asset markets") in order to make them less predictable. If the strongest form of the EMH holds, financial markets are already working just fine and you don't need to innovate or deregulate.

      But see, I pretty much guarantee you that this fact didn't come into play. What happened was that people threw around the term "efficient" without knowing what the hell they were talking about, because it sounded good, and because deregulation was the popular fad of the day (and it hadn't crashed the system yet, so people thought they were safe). The actual content of the real EMH had essentially zilch to do with this process, other than its unfortunate name.

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  26. To reformulate the EMH.

    "The efficient markets hypothesis states that markets are efficient at processing information about what prices should be in a market".

    I know it's not quite true, either as a statement or as a statement of what the EMH actually says.

    But it's a definition which gets the important point across to non-specialists. It isn't stating that markets are "efficient" (Pareto and all that). But it is stating that most (semi-strong version) to all (strong)information is already in those prices you can see.

    I find it useful anyway: although usually in arguments with the more deluded commentators on matters economic. I have actually seen someone use the argument: because we had the crash markets are not efficient thus medical care should solely be provided by the government.

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    1. Herman10:04 AM

      "The efficient markets hypothesis states that markets are efficient at processing information about what prices should be in a market".

      To operationalize your definition an asset pricing model is needed. But the asset pricing model plus EMH joint hypothesis is rejected by the data for every known model. Then there is the excess volatility issue.

      The implicaion being that for any given model, the market is, in general, *not* 'efficient at processing information about what prices should be in a market'. Fischer Black, for example, used to argue that CAPM is the right model and so what is rejected is the EMH.

      Further, the excess volatility suggests that a lot more besides 'information' is moving prices. And it is clearly not changing risk tolerance. Actually, given that nobody has discovered the 'right' asset pricing model it is difficult to see how one can even distinguish between information and noise.

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    2. Surely all we get from EMH is the idea that a good deal - but not all- of information finds it's way into the market.
      This does not guarantee that the information will result in prices being at or even close to a fair value - which is based upon guesswork about future income streams.

      Stock prices and (to a lesser extent)whole stockmarkets are risky places and much more risky than the accepted random motion normal distribution models lead our financiers to believe. Read this. http://www.nottingham.ac.uk/business/cris/papers/2008-3.pdf

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  27. Phil Koop11:42 AM

    Thinking more about this, I do not see why you dragged Samuelson into it, except as an excuse to mention a classic paper.

    Samuelson did not say that changes in spot prices cannot be anticipated. He said that if spot price changes *can* be anticipated, then *futures* prices would be martingales after proper discounting. This is completely irrelevant for the representative retail investor, who is not going buy a futures commodity contract, but rather to buy an equity on the spot market and hold it. Not only did Samuelson not prove that portfolio is a martingale, he *assumed* it is not!

    The real reason retail investors should not take positions in single assets is that to do so presumes not only that the investor knows the law of the asset in question, but that the market does not. She thus needs to be able to answer two questions: 1) what is the law governing returns on this asset?, and 2) why does the market not know this law?

    It is irrelevant but still interesting to note that the convergence between spot and futures prices that Samuelson assumed was guaranteed by arbitrage has in fact been violated for several ag commodity contracts, including the wheat futures he used as his example.

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    1. Thinking more about this, I do not see why you dragged Samuelson into it, except as an excuse to mention a classic paper.

      I generally disapprove of this sort of phrasing. I didn't "drag Samuelson into it", and the fact that the paper is "classic" is irrelevant.

      Not only did Samuelson not prove that portfolio is a martingale, he *assumed* it is not!

      But the proof about futures prices is very helpful in understanding the idea of random markets.

      The real reason retail investors should not take positions in single assets is that to do so presumes not only that the investor knows the law of the asset in question, but that the market does not. She thus needs to be able to answer two questions: 1) what is the law governing returns on this asset?, and 2) why does the market not know this law?

      Yes, adverse selection is IMHO the other fundamental fact of financial markets. But people are amazingly good at ignoring it...

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  28. Anonymous5:44 PM

    Great post Noah!

    It is sad really that more people do not have this good baseline. I have a good friend that invested heavily in real estate over the last 12 years and stocks. I think he may have less money than I do now, since I just sat on cash and invested in a low-cost 401(k).

    He is a smart guy but again, you should really only be investing beyond a 401(k) or IRA or speculative real estate if you make more than $200 grand a year, in a real snoop jobby-job...

    Frank

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  29. The greatest value of EMH is in getting people to realize it's very hard to earn excess returns, and that people generally overpay for active management. But there are well-documented anomalies, such as value and momentum. Efficient marketeers have gotten too skeptical about being able to beat the market, while others erroneously think its easy to do.

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  30. Keshav Srinivasan6:21 PM

    Noah, here's what may be a useful expansion of your RMI that I got from reading James Kwak's blog: most people can't reliably pick stocks that beat the market. There may be people who can, but most people can't reliably pick people who can reliably pick good stocks. And there may be people who can even do that, but most people can't reliably identify THOSE people either, etc. So it's sort of like an iterated version of your RMI.

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    1. Keshav Srinivasan6:29 PM

      To express it in a more pithy fashion: stock price movements are randomly distributed among stocks, stock-picking strategies are randomly distributed among people, stock-picker picking strategies are randomly distributed, etc.

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  31. Anonymous3:18 PM

    This is stupid. You know what else is random? Poker hands. And typically when you play for money, there's also a rake. So you not only have to be better than your average opponent, you have to be better by enough to overcome the rake. The situation is exactly analogous, yet plenty of people are able to make money playing poker. If financial transactions cost money to make, then it is necessarily the case that, on average, people who pay for them are doing worse that people whose money just sits in some idealized perfect market spread. That doesn't mean it is "very, very, very unlikely" that an individual will do better than that.

    More importantly, investing in a perfect reflection of the market is not some automatic button you can check - you still need to choose a vehicle that encapsulates the market, and whatever set of choices you make about what best captures market growth are subject to the same biases and lack of information, and have a tendency to become outdated. So it's not like there's some obvious "put your money here, you dolt" investment strategy that all these suckers are missing out on by trying to take charge of their investments.

    If you go through that article, it finds a bunch of flaws (very similar ones to the flaws poker players make) that investors have. You think that those investors can't improve their finances by minimizing the effect of those flaws on their investments? What is this safe haven portfolio that will consistently make the expected value of your RMI and requires no intervention by the investor except to put more money in whenever they can?

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  32. As someone who trades for a living this article strikes me a bit naive. After years of training to trade properly, it became apparent that guessing price movements is very difficult to do and should be avoided as it is unnecessary to do so.

    Rather, it is far more important to incorporate a set of strict money management techniques which are highly effective when coupled with a reactionary trading style that solely relies on price information.

    To attempt to pick the best investment based on fundamental analysis is a play in the hands of institutions. Instead, it is far more likely that successful non-institutional traders will take money from novices who attempt to do so. This statement is not meant to suggest that anyone can ever know who is gaining from another in the market place. It speaks more to the idea that those that consistently lose are the ones who supply the returns to the small group of profitable traders.

    Also the goal is not the beat the market average, but to manage risk and participate in favorable price movements when they occur. That said a positive expectancy model could very well beat the market consistently with this being the goal.



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  33. Rafael is absolutely right. The profitability of numerous trend-following strategies (verifiable through backtesting over decades) is ample evidence that prices do not react instantly to all available information, but often take weeks, months or even years to absorb the implications of new information.

    For example, the inevitable collapse of Enron was apparent months before the share price fell to zero. It was an obvious short and yet many people clung onto the shares until the bitter end.

    It was the same in 1929, 2000 and 2007. The markets adjust in slow motion, allowing ample time for traders to benefit from the price trend.

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  34. "people should realize that the EMH is misnamed"

    I like the term Yudkowsky uses to describe the EMH. He says markets are "anti-inductive"

    http://lesswrong.com/lw/yv/markets_are_antiinductive/

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