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My Opinion About Stock Market Efficiency (7 May 20102)

There are thousands of books about effective market (some of them written by leaders of Effective Market Hypothesis /EMH/ are quite good) and already several dozens of books about ineffective market.

I think that existence of long-term premiums or /mostly/ discounts to net assets values for closed-end funds ( is the simplest evidence of stock market inefficiency (fig.1).

Fig. 1

But at first glance EMH has good logic and to some extend confirmed by market data. So why EMH and it derivatives are wrong?

IMO the main EMH weakness is operation with such ill-defined term as risk and oversimplification of reality in sake of nice mathematics. For example initial assumption that risk (in terms of volatility, beta, covariances, etc...) is related to return is simple incorrect (see e.g., fig.2)


As the result EMH, MPT, CAMP, etc... are related to stock market as dresses for girls at podium of fashion show are related to dresses for average women (former are probably more elegant, later are that mass production should target).
I'd rather agree that market "is USUALLY incorrect than ALWAYS incorrect" just because market or stock crosses CORRECT point when it goes from negatively /positively/ incorrect to positively /negatively/ incorrect. It is at least very difficult to figure out the correct point in the permanent noise of stock market. Trade parties have usually opposite assumptions about the correct point and only in average (for zero sum game at zero fees) no party is right and only a guy who collects fees is a winner. So EMH zealots make shortcut and declare that each point is correct (which is not true IMO) and suggest reduce investor expenses e.g., via index funds (which is true IMO only when it is cheaper than individual stock selection). EMH zealots to some extend understand stupidity of the "ALWAYS correct" claim and prefer to refer to whole market which has smaller fluctuation than each single stock or limited group of stocks.

EMH zealots have found conformations in stock market data but EMH opponents also have found stock market data that contradict EMH (see for example "Finding Alpha" by Eric Falkenstein - short note about it in Any physicist well knows that any smart, logic and well established hypothesis should be dismiss if a correct experiment result contradicts the hypothesis. IMO, this is now the case for EMH because there are already several evidences that this hypothesis is incorrect.

I'd like to finish this post with quote from Eric Falkenstein book ""One of the biggest things people do is persuade others; and to be a good persuader, it helps to truly believe in that you are selling." I think it is applicable not only to EMH zealots but almost to anything we heard from Wall Street.