Will the Efficient Markets Hypothesis Survive This Crisis?

The efficient markets hypothesis, the bedrock of modern finance, is under attack due to -- get this -- irrational behavior. Believe it or not, it appears that some market participants behaved irrationally. So where does that evidence leave us?

What is the efficient markets hypothesis? The Wikipedia definition is pretty good:

"... the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information."

The implication of the efficient markets hypothesis is that trying to pick the best stocks or bonds will not do better than buying an index fund.

There have been a number of anomalies reported that cast doubt on the efficient markets hypothesis. Most notably, the behavioral finance researchers have found plenty of biases in human decision-making. These include recency bias (a tendency to put greater weight on recent performance than it deserves), herd behavior (doing what everyone else is doing), and framing bias (in which risky bets to make a gain are shunned, but equally risky bets framed as avoiding a loss are embraced). The housing boom-bust, and the related booms-busts in mortgage-backed securities, reinforce the irrationality of much human decision-making.

But where does that leave us? The efficient markets hypothesis may be overstated, but what actionable consequences does that leave us with? The behavioral finance researchers have not presented a better way of estimating value than current prices. They have simply cautioned us that current prices are not terribly accurate estimators of value. Here are the lessons as I see them:

• To investors, buy and hold a diversified portfolio still looks to be the best strategy, but do not take long-run average returns to be accurate indicators of what you will actually earn over your holding period.
• For companies, be very suspicious of strategies based on the assumption that the company can predict prices better than the market can. (I once knew a mining executive who assumed that most of his gold production would be sold within 10 percent of market tops. Talk about hubris!)

These conclusions generalize. Even if a theory is found to be inaccurate in some regards, that does not imply that alternative behaviors are automatically proved to be optimal. For example, finding that the classical economic conditions of perfect competition are not met does not necessarily imply that our government's intervention in the markets is optimal.

Comments

[Moon Kil Woong:]

All I can say is it seems to work fine on the micro scale. Especially when applied to options. What a buyer and what a seller agrees to pay for an item is still the best gadge of a stock's value despite what banks will tell you. At least they are putting their money where their mouth is.

Which brings up program trading and HFT that goes with it. First it's not people betting, its computers. Second is that a lot of prices are faked, putting up bids that they don't want executed and trading anoung themselves to create the perception of price action. That is why I advocate to limit or ban this. Especially when they create ways to steal away orders before they hit te exchange so as to obscure price discovery and real volume from the rest of the market. As they say, "There ought to be a law against it."

Aug 12 04:05 AM

[Tom Armistead:]

The only area where the market is efficient is separating the fool from his money. It also chips away at the resources of careful and prudent investors, nickeling and diming them to death as discussed by Moon Kil Woong in his comment.

On the pricing of assets the market is extremely inefficient. A casual glance at the various lists of stocks that have doubled, tripled, quadrupled, etc., since the March bottom is enough to demonstrate this beyond any doubt.

The inefficiency in performing the pricing function is part and parcel of the efficiency of separating the fool from his money, or taxing the careful and prudent investor on each transaction.

Aug 12 06:39 AM

[chap08:]

The EMH is dead, but it will live on, zombie like. You will see it emerging from a graveyard near you, arms outstretched, eyes wide and a rictus grin on its face. The reason for this life after death is that it has elements of truth within it and, most importantly, the conclusions are largely true (though not because the theory is true).

Anyone who has been around for long enough will tell you that it is extremely difficult to beat the market long term. You either need luck or a long list of attributes like skill and dedication. Even when you are right, the market can make you wrong. For example, let's say you thought techs were getting over-valued in 1998 and that it might be an idea to short them. You might have been right but you'd have been killed (or lost your job, as some did).

Even if you have a proven strategy, don't expect to win. Value investing had a proven record of success, but value investors also lost their jobs in 2000 and got killed again last year. I think it will be particularly interesting to see what happens to momentum investing. Momentum has a long record of success and is recognised as an unexplained anomaly by those who still believe in EMH. Now that momentum funds have been created and everyone is diving in, will the market take it's revenge?

Aug 12 07:31 AM

[Living4Divi...:]

EMH has been disproven a while back. The only problem is no one has really come up with an replacement theory, so EMH lives on. The market is somewhat efficient (say a reduced form of the Weak Form of EMH)

I also agree with Tom that "the market is efficient is separating the fool from his money."

Aug 12 07:56 AM

[frosty:]

An "hypothesis" is a statement or problem subject to rigorous proof. It seems EMH cannot be proven or disproven. It has believers and disbelievers. Godel addressed this dilemma with his proof that "in any logic, there are true statements that cannot be proven." What is the solution? EMH is an axiom not an hypothesis. You can either accept it as part of your logic or you can reject and substitute an alternative. Do you believe people act irrationally? Some physicists and philosophers believe that there is no such thing as 'free choice' - that we are ruled deterministically by the laws of the universe set in motion 13 billion years ago. Can this be proven or disproven? No, but as an axiom, it is part of the foundation for some interesting physical theories.

Aug 12 08:27 AM

[SW Richmond:]

EMH should probably be viewed as a restatement (in brief, for the ADHD modern 'investor') of Mises' famous essay 'Economic Calculation in the Socialist Commonwealth'. In that short essay Mises explains why Socialist systems cannot work long term; the simple reason being, they short-circuit the sending of price signals and cause gross misallocations.

EMH simply states that pricing signals, in a market in which information flows quickly and freely, will be available to all in a timely manner; thus, many market participants will be able simultaneously to take advantage of the information.

Of course, EMH relies on information flowing freely in a free marketplace. Herein lie the difficulties.

1. Major market players have gone off-exchange into dark pools, seeking to hide their trades. This deprives markets of information, and it is one way big players seek advantage.
2. Governments and central banks have grossly distorted markets. They have entered markets and manipulated them, both overtly and covertly, with asset-purchase programs, backstop guarantees, etc. ALL THESE PROGRAMS ARE SPECIFICALLY DESIGNED TO PREVENT PRICE SIGNALS FROM BEING SENT.

3. Governments and central banks have further interfered with price signals by altering or preventing, in real time, the application of accounting standards that would aid investors in evaluating the actual financial conditions of companies.

4. The U.S. government has smashed and taken over large corporations on terms favorable to political constituencies, using its own 'judicial' system to achieve its ends with Blitzkrieg efficiency, and continue to threaten to take over the health care industry in a similar manner, fully 17% of GDP.

Price signals don't have a chance. Do not mourn EMH's failure, it was shoved aside by government.

Aug 12 08:39 AM

[kingaj12:]

EMH is more of a slogan than a principle. It needs to be replaced by a much more careful analysis of how information flows in markets.

Aug 12 08:47 AM

[David Van K...:]

There's more to EMH than informational efficiency. It also requires that market participants process that information intelligently, fully, and realistically to maximize their own best economic interests.

Plain common sense, combined with routine observation of the market, tells you that classic EMH cannot be true. It's a market, and things are worth what people are willing to pay for them. At any time, a stock's price is based on the aggregate apparaisal of active participants who are trading that stock. This composite perception has a strong emotional component to go with hard information, not to mention the mechanical component intrduced by programmed trading. Plus, some players are ignorant of of a portion of the available information, some of the "information" is mere speculation about the future, and some of the traders do not process that information very intelligently. (Read some of the comments around Seeking Alpha and make your own judgement about how intelligently some of your fellow investors are processing information.)

I think that a "weak" form of EMH may be the best way to look at it: Over long periods of time, movements in a stock's price "directionally follow" what might be called the "correct" price, but there are constant adjuctments being made based not only on rational processsing of valid information, but also on emotions, erroneous perceptions, ignorance, irrational processing, and incorrect information. This results in investment opportunities for those who are doing a better job of it.

Aug 12 08:47 AM

[Common Cents:]

EMH is dead in my mind. The proved psychological biases that you indicated and short-term computer drive momentum/manipulation seem to be overwhelming evidence that EMH is dead. How else can double digit percentage moves over the course of a week/month be explained. Information/fundamenta... just do not change at the rate.

While we are taking shots at "theory" I'll put my vote into the camp that says strategies based on "normal" distributions of price movements are not very helpful.

Aug 12 09:27 AM

[Alex Filonov:]

Barry Ritholtz proposed in his blog a parallel universe where exists Deficient Market Hypothesis.

Aug 12 10:08 AM

[unclej0:]

It is reasonably clear that markets are irrational. Otherwise, how could the well informed, highly educated bankers in our largest investment banks have led our economy to the brink of ruin, where it still seems to be? How could the rating services have given an AAA rating to mountains of toxic assets?

My question at this time is as follows: can the purveyors of gloom and doom among advisory services, currently Weiss and Leeb, be calling the shots as they see them or are they simply creating a self fulfilling prophesy - or both?

Aug 12 11:28 AM

[unclej0:]

Your number 4 seems to blame government when, in fact, it was reacting to an emergency created in part by believers in EMH. There is no way to argue that, prior to government intervention, the health care industry had much resemblance to an efficient market. In the case of the auto industry, it was rescuing two companies from their own incompetent management. If that market had been rational, this incompetence should have been reflected more fully in the stock prices well prior to 2008.

It seems to me that the inflated earnings of CEOs contradict the EMH. Were they actually worth it?

How about accounting fraud? An unregulated market is a thieves' paradise. Contrary to simplistic opinion, if an approximately efficient market could exist, it would be a very tightly regulated market.


On Aug 12 08:39 AM SW Richmond wrote:

> EMH should probably be viewed as a restatement (in brief, for the
> ADHD modern 'investor') of Mises' famous essay 'Economic Calculation
> in the Socialist Commonwealth'. In that short essay Mises explains
> why Socialist systems cannot work long term; the simple reason being,
> they short-circuit the sending of price signals and cause gross misallocations.
>
>
> EMH simply states that pricing signals, in a market in which information
> flows quickly and freely, will be available to all in a timely manner;
> thus, many market participants will be able simultaneously to take
> advantage of the information.
>
> Of course, EMH relies on information flowing freely in a free marketplace.
> Herein lie the difficulties.
>
> 1. Major market players have gone off-exchange into dark pools,
> seeking to hide their trades. This deprives markets of information,
> and it is one way big players seek advantage.
> 2. Governments and central banks have grossly distorted markets.
> They have entered markets and manipulated them, both overtly and
> covertly, with asset-purchase programs, backstop guarantees, etc.
> ALL THESE PROGRAMS ARE SPECIFICALLY DESIGNED TO PREVENT PRICE SIGNALS
> FROM BEING SENT.
>
> 3. Governments and central banks have further interfered with price
> signals by altering or preventing, in real time, the application
> of accounting standards that would aid investors in evaluating the
> actual financial conditions of companies.
>
> 4. The U.S. government has smashed and taken over large corporations
> on terms favorable to political constituencies, using its own 'judicial'
> system to achieve its ends with Blitzkrieg efficiency, and continue
> to threaten to take over the health care industry in a similar manner,
> fully 17% of GDP.
>
> Price signals don't have a chance. Do not mourn EMH's failure, it
> was shoved aside by government.

Aug 12 11:49 AM

[Gregman2:]

Many theories and assumptions, including this one, need to be reexamined. Information is not as universally accessible as it is assumed to be, especially as it relates to capital and labor.

Aug 12 12:12 PM

[SW Richmond:]

'Your number 4 seems to blame government when, in fact, it was reacting to an emergency created in part by believers in EMH.'

Ridiculous. The emergency was created by the Fed, a quasi-government agency, which inflated a bubble in order to pump tax revenues to help pay the costs of smashing and occupying a sovereign foreign country. The existing regulators were either asleep or waiting for the door to revolve so they could have their turn in high-paying WS jobs. WS IB's push the concept of 'too big to fail' through laundered bribes called 'campaign contributions', guaranteeing that their profits will be private while their losses foisted onto the backs of taxpayers.


'There is no way to argue that, prior to government intervention, the health care industry had much resemblance to an efficient market.'

The government began the distortions in health care by forcing employers to offer benefits rather than salary during wartime, via the mechanism of salary caps; those distortions were amplified by medicare and medicaid. Inefficient market? Get the government OUT.
books.google.com/books...


'In the case of the auto industry, it was rescuing two companies from their own incompetent management. If that market had been rational, this incompetence should have been reflected more fully in the stock prices well prior to 2008.'

Again, ridiculous. Automobile production was unsustainably high; this was achieved by pulling forward demand through artificially low interest rates, again the purview of the Fed. Companies respond to the economic environment they are in; that environment was created by the Fed. Management WAS incompetent for failing to recognize the bubble. Again, when price signals are thwarted, misallocations ensue.


'How about accounting fraud? An unregulated market is a thieves' paradise.'

A regulated market is a politicians' paradise, giving larger and unwarranted power to professional liars. Guess who the regulators work for? Can you say 'too big to fail'? I knew you could.

So much for your socialist workers' paradise.

Aug 12 12:25 PM

[carey_jim:]

It's clear that financial behavior is not different from the rest of human behavior which is best studied by studying history.

History shows that wisdom and intelligence have not had a role in human history or financial history, other than as a tool to try to predict which way the mob will turn next and to either get out of their way or march along with them.

Many people pretend to be ignorant of history but almost everyone has read enough of it to know that.

Socialism, which is supposed to be the intelligent, democratic management of the goods and services of an economy by a highly trained elite, is subject to the same basic irrationalities that every other system is, as we've seen in various socialist republics of the twentieth century. Most people have read enough history to know that too.

"Free" enterprise is, basically, "get out of the way" economics and recent history has shown that it doesn't work either.

So what's next?

Aug 12 02:24 PM

[rosey99:]

In the context of economics, words like "theory" and "hypothesis" are often abused to the point they lose meaning. As another commenter pointed out, a theory or hypothesis can be refuted, while much of what the discipline of economics passes off as "scientific," can not be proven false, so it can never be proven correct. Most of the conjectures of economists are better classified as philosophy, and often as sophistry. Ideology posing as science usually has this flaw. But our collective need to invent "hypothesis" and "theories" in an effort to reinforce our preferred beliefs seems to be built in to human beings. Maybe it's hard-wired?

Did the emergence of neo-classical economics cause politics and policy to change in the 1970s and 1980s, or was it the other way round? It seems to me that there is a reflexive relationship at work here; politics fed economics, and was in turn fed by politics. And both are really philosophy in the guise of the "social sciences."

Aug 12 03:56 PM

[Xyrus:]

I don't think there's an either or. I think it is spectrum ranging from a completely inefficient market to an efficient market.

An efficient market would essentially look like brownian motion. In a perfectly efficient market, timing would be nothing but a matter of luck. There would be no way to beat the market.

However, that is not the market we have. The question isn't whether the markets are inefficient or not. The question is are the inefficiencies prominent enough for one to be able to take advantage of them.

Most of the inefficiencies in the market are short duration and/or small discrepancies. Only well connected or deep pocketed investors would be able to play these well. But more importantly, a lot of them are random as well.

So another question is, if a market has inefficiencies that a short, small, and/or random, at what point does it become indistinguishable from an efficient market? In other words, can there exist a market that has inefficiencies that you can't time?

It's my opinion that we do have a mostly efficient market for MOST investors, i.e. the inefficiencies are either too small, too short, too random, or some combination of the three that really only the big players can truly take advantage of them.

~X~

Aug 12 03:57 PM

[Joseph Nicolay:]

As long as people continue to believe in EMT, I (or we) will continue to profit from it. What would our world be like if every investor was searching for a bargain?

Sep 10 08:43 PM