I’m having an interesting discussion with my professor on EMH and I’m trying to show him the failure of EMH to explain bubbles. He’s taking the position that the price of the assets at the height of the bubble took into account all known information. When new information was known the market adjusted. I’ve mentioned low interest rates, but have stopped short of fully explaining ABCT.
Anyway, my question to you guys is…in a pure laissez faire economy with no fed distortions, no regulations etc, would you buy into the efficient market hypothesis? That is would you beat the market half the time and fail to beat it the other half? If you consistently earn a higher return than the market, would just call that luck?
To piggyback on this post, I am also curious if there is a distinction between the Efficient Market Hypothesis and Efficient Market Theory, or if they are one and the same. My search leads me to believe that EMH and EMT are one in the same, although I rarely hear the latter used.
If you can kindly explain why everyone would beat the market half the time, then I might buy into it. As is, it sounds pretty silly.
Of course we can test it by going to ESPN.com and checking if their experts predicted game outcomes about 50% of the time. If they didn’t that would kill the EMH, no? If they did, it would need further testing, and even more, a solid reasoned explanation.
The theory goes that markets (particularly stock markets) price in all available information. This means that you don’t have any more information to base your investment decisions on than the millions of other people pouring over the data. The implication is that for a given level of risk, in the long run you will be unable to earn a higher return than the market average. So if market has a beta of 1.0 and a return of 8%, you may earn either above 8% or less than 8% on a particular stock with similar risk, but in the long it will average out to 8%. Again, if you don’t have any different information than the millions of other investors, how can you consistently earn a higher return than them?
So all people are equally intelligent? And they all think the same way? Why is there ever any disagreement about anything at all, seeing as we all have the same information? Why do debates not end with one side conceding every single time?
Bottom line, there are two assumptions that I don’t see the evidence for. That everyone has identical information, and makes the same use of it.
This would imply the “strong form” of the hypothesis. Obviously insider information takes time to filter through to the entire market. Which is why I would reject the strong form.
It doesn’t assume that everyone acts the same. In fact it’s exactly the opposite. Some people will price the stock below the market average and sell, others will prices it above the average and buy. This is how market prices are formed. But it suggests that half will be right and earn an above average return, and half will be wrong and earn a below average return.
Again this implies strong form. I think the real question is whether it is weak and semi-strong form.
What is the basis for assuming that half will be right and half will be wrong?
The OP seems to be saying that no one can beat the market, because the law of averages will make sure he is wrong half the time.
I don’t see any basis for such an assumption. We may all have the same information, but some people know what to do with it.
As a simple example, some people have been saying for years that gold will go up up , up, and giving their reasons. Does the EMH say they were just lucky? That they may think they know what they are talking about, but they really don’t?
Couldn’t one make the claim that the ones who know what to do with it will drive the ones who don’t out of the market? Wouldn’t that mean that the only people remaining would be the ones who know what to do with the information? If that is the case how can one of these individuals beat the rest on average?
Your gold example isn’t a very good one because government policy distorts market fundamentals. We are assuming pure laissez faire here.
2. I don’t see why govt policy distorting fundamentals should change the argument. The existence of the govt is not a secret. Everyone has that info.
Everyone does not have the same info when dealing with government. If they did then everyone would have avoided investing in the housing market knowing that Fed policy was just creating an unsustainable boom. How can you possibly make that claim? Same thing with gold. If everyone knows impact of the fed’s policies then people would have invested in gold years ago.
The EMH is merely the application of Rational Expectations to financial markets. It basically says that markets price better than individuals (because of arbitrage). If individual’s continuously “beat the market,” in the average, then it would mean that individuals are better at pricing assets than the market (beating the market should be a random occurrence). In other words, it would mean that markets are inefficient. I believe that this theory only holds (the weak version) when there isn’t continuous government intrusion within markets, especially within money and capital markets. The strong version of the EMH is demonstrably false and it makes no sense (prices represent “intrinsic” values).
The EMH is merely the application of Rational Expectations to financial markets.
If rational expectations is disproven, would that imply that EMH (weak or strong) is disproven as well?
Rational expectations suggests the standard economic assumption that people behave in ways that maximize their utility (their enjoyment of life) or profits. From the Austrian perspective, rational just means purposeful, not necessarily financial maximization. Furthermore, value is subjective. This would runs counter to rational expectations.
There’s one more thing. It’s not “people behave in ways that maximize their utility”, but rather “people behave in ways that they think will maximize their utility”.
Big difference. Cause there are a lot of mistaken people out there.
I definitely believe in the weak version of the efficient-market hypothesis. Failure to explain “bubbles” is not necessarily a weakness of the hypothesis if the term “bubble” itself is incoherent. Quoting Eugene Fama, “I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
I must admit I still find it hard to intellectually grasp what it means to know that a security, for instance, has radically departed from a fundamental value and will eventually return to that value; such knowledge would (if we are to believe basic economic theory) provide a strong incentive for arbitrage.
The trouble I have with EMH is that any time I buy something and resell it for more than I purchased it, I have “beaten the market.” If it were not possible to beat the market, then profitable business (or profitable-anything-else for that matter) would not be possible. Entrepreneurs are actually identifying profit opportunities (disequilibria, if you like) and exploiting them to make money, thereby, “beating the market.”
So, it would be impossible for a fractional-reserve bank to profitably engage in credit-inflation while simultaneously shorting the market into which it is lending? I don’t see anything logically impossible about this, or even difficult to comprehend.