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Vladimir has been fascinated with financial matters for as long as he can remember. An engineer by trade, he spends his free time studying history of financial markets and associated human behaviors, reading various financial reports, analyzing policies, discussing various theories on related... More
  • The Efficient Life Hypothesis 5 comments
    Aug 21, 2009 10:03 PM

    No, this isn't a hot stock tip or an attempt to discuss a particular stock, index or specific sector or a market. For those of you who were expecting that, I apologize.

    Much has been said and written lately of the Efficient Market Hypothesis (EMH), but I still would like to try to make a small contribution.

    About 10 years ago I met a person who seemed equally interested in financial markets, we hit it off and had many interesting discussions on various financial topics over the years. I still remember his first question very well, or, to be more specific, his second question. His first question was if I invested in individual stocks or just index funds. When I said yes to stocks he gave me a funny look and asked me if I was familiar with the EMH. I don't remember exactly what my response was, but I'm sure it was either too long to be interesting or too brief to have enough evidence to adequately support my view.

     

    This story has repeated itself several times over the years and I finally decided it was time to analyze this question properly and prepare a better argument for discussing EMH and its real world applicability.

    I used a method that mathematicians sometimes use when analyzing a problem: I've decided to scale it up. Let's make our market bigger. So big in fact that it becomes the universe itself. Everything that's going on in this life is part of it. Everything is a traded asset. Let's now assume this imagined universe to be efficient. All information in it flows freely. Price of every asset instantly reflects it.

    Would it make sense for a human being in this universe to choose a career based in part on financial consideration? Would it make sense to spend more time and money getting into a higher paying career or do unskilled labor for life? Present Value of future cash flows from both careers would be exactly the same.

    Would it in fact make financial sense to acquire any skill? Would it be beneficial to develop ones intellect for the purposes of being able to compete? Would it even make sense to get a job or to do anything at all? If something is worth doing (based on information available) it would have already been done by someone else! Homer Simpson's slogan “Can someone else do it?” comes to mind. If there is life in this efficient universe, what kind of life would it be? Let's call it the “efficient life”.

    Can efficient life actually exist? Is it death?

     

    Let's step back and take a look at real life as we know it. It's hard to quantify, but I think it's obvious that for most people, real life isn't exactly efficient. Either it's completely inefficient or it can be statistically described as 99% efficient, but the real world implications of the remaining 1% are so huge that our lives are far from assuming that “if something is worth doing it would have been done already” and just sitting on the porch and waiting for happiness to come on its own.

     

    Ok, so we don't know how efficient real life is, but we do know that even if it is, that doesn't help us run our lives. What else do we know? Can we say that life in some geographies is more efficient than in others? Let's compare continents, countries, cities, small towns, neighborhoods. I'm not going to ask you to point them out on the map, but I imagine you could. Aren't markets the same way?

     

    I know, I'm not giving you any answers, just raising questions. But I believe this is useful ammunition.

    If anyone ever asks you what your opinion is about the EMH, just ask them what they think about the Efficient Life Hypothesis and they'll likely be able to answer their own question.

    Themes: EMH
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This post has 5 comments:

  •  
    Well said. I would add that, assuming the world was entirely efficient, wouldn't society be faced with a glut of petrochemical engineers, or whichever occupation offered the highest salary at that particular point in time?
    Aug 21 11:10 PM | Link | Reply
  •  
    Interesting...My general observation is that theories arise from human attempts to model behavior within the parameters of a rational system. The correctness of any theory is either determined by its predictive ability or merely by the number of folks ready to believe it irrespective of facts. The theory of efficient markets appeals to reason in that assuming rational behavior of market participants - traders and aribitrageurs etc. and instantly available information, it would be reasonable to expect the market to price efficiently since any in-efficiences are instantly targeted by arbitrage.

    Facts do not support EMH in the short run or even in the long run for individual equities. There are obvious reasons such as the velocity of information, cost of arbitrage, corruption etc. However in the long run for large collections of stocks or other instruments, it is difficult to rationalize how inefficiencies can be maintained in a free system. Perhaps an analogy may be to the brownian motion of say pollen particles in stream of water that follows the gradient on some terrain. The individual pollen particles (stocks) make various random movements as they get kicked around by the surrounding water molecules (market participants, trade activities/.) but generally follow the stream (market/information) on its way down the gradient. Thus though the individual stocks display many movement characteristics that are unrelated to the market and available information, over the long term they follow a pattern that is determined by the information landscape. One major issue with this analogy is that my individual experience is that stocks tend to make such large deviations from the information terrain that it gets hard to determine which factor dominates; the other issue for application of the theory is what constitutes "long term"..

    I see how ELH contradicts our daily experiences. However there are two assumptions it makes. One that the participant has a choice with regard to participating. That is generally not true for ELH. You could have two equal opportunity paths but be always compelled to take at least one (as in need a paycheck) ..The other is the "rationality" of the participant. Being imperfect creature composed of other random particles and urges we humans almost never act on reason alone ...
    Aug 22 03:01 PM | Link | Reply
  •  
    > I see how ELH contradicts our daily experiences. However there are
    > two assumptions it makes. One that the participant has a choice with
    > regard to participating. That is generally not true for ELH. You
    > could have two equal opportunity paths but be always compelled to
    > take at least one (as in need a paycheck) ..The other is the "rationality"
    > of the participant. Being imperfect creature composed of other random
    > particles and urges we humans almost never act on reason alone ...

    I agree with both choice and rationality aspects.
    However, I don't see major differences in how they affect both ELH and EMH. So if ELH can't exist, so can't the the EMH.

    Market participants don't have a choice not to participate. If one has assets, one is in some market. I suppose one could donate everything and then not play, but that's not an option for most of us.
    If one doesn't buy securities or real estate and keeps all savings in cash, one is long dollar or whatever the local currency is, so one is still participating.

    I can't tell if market participants are more or less rational than life participants, but both have historically demonstrated significant degree of irrationality and that must affect both ELH and the EMH.
    Aug 22 08:42 PM | Link | Reply
  •  
    I think a fundamental weakness of EMH is indeed the "rational" participant assumption. EMH does not need everyone to be rational but assumes that the majority is capable of rational decisions over time. I have seen too many instances of irrationality both at the individual and group level to quite believe that. The problem is what does this leave us with in terms of modeling market behavior. Once we make an irrationality assumption, almost anything goes. Perhaps that is why significant sectors of the market display statistically rare behaviors. e.g. the move in oil (think it was close to a 5 sigma deviation ~= a few dozen in a million type of probability, if I am getting the math right) that brought down amaranth...
    Aug 30 10:29 PM | Link | Reply
  •  
    With all of those computers and models, most of what moves markets is still fear and greed. Neither of those are particularly rational.

    Btw, amaranth went down after doubling down on natural gas spreads, not oil. I'm not sure how to calculate probability on those spreads. My understanding of what happened is that Hunter placed spreads hoping to gain on some sort of temporary disruption (hurricane, etc). When that didn't materialize he doubled down repeatedly, I'm not sure if he was trying to move the market on purpose but while he did move it for a while eventually it turned against him and by that time position sizes were out of control and margin calls came.
    I think this was greed in combination with a lack of fear that is characteristic of certain "invincibility" feeling that Hunter must have had at the time, given he was previously successful and became "untouchable".
    One can argue that what he didn't wasn't rational from the market point of view, but perhaps from his own it was quite rational. You bet big and if you lose - it's not your money so your personal loss isn't proportional to the bet lost. If you win - you're often rewarded proportionally to the bet won.
    So perhaps his behavior (intentionally or not) was quite rational on some level, yet this doesn't help the market to be rational and is another example of how EMH makes a faulty assumption about participant rationality.

    On Aug 30 10:29 PM nostradumass wrote:

    > I think a fundamental weakness of EMH is indeed the "rational" participant
    > assumption. EMH does not need everyone to be rational but assumes
    > that the majority is capable of rational decisions over time. I have
    > seen too many instances of irrationality both at the individual and
    > group level to quite believe that. The problem is what does this
    > leave us with in terms of modeling market behavior. Once we make
    > an irrationality assumption, almost anything goes. Perhaps that is
    > why significant sectors of the market display statistically rare
    > behaviors. e.g. the move in oil (think it was close to a 5 sigma
    > deviation ~= a few dozen in a million type of probability, if I am
    > getting the math right) that brought down amaranth...
    Aug 31 11:08 AM | Link | Reply
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