

An Infinite Regress. Of Dumb: More Reflections on “Market Efficiency” - nkurz
https://medium.com/bull-market/the-last-time-i-saw-richard-thaler-speak-he-talked-about-the-beauty-contest-game-in-the-beauty-2e0b767d9098/

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exelius
When doing any sort of theoretical work in finance or economics, academics
often make the _assumption_ that markets are rational and efficient. This
assumption is almost universally false. They know that markets are neither:
markets may or may not be rational (we can never realistically gather enough
data to know thanks to information asymmetry) and they certainly aren't 100%
efficient over most timelines.

Just because the assumption is wrong doesn't mean it's not useful: without it,
you can't even build a reasonable model of financial markets. But because the
assumption is core to financial modeling, this means that all financial models
are wrong. In fact, that's exactly how my financial modeling professor opened
up the first class: by explicitly stating that all models are wrong in some
way. You have to understand the ways that the model can be wrong in order to
make any substantive claims about it. The Black-Shoals options pricing model
assumes market liquidity; it's not very useful if you're talking about an
asset that isn't very liquid.

Misunderstanding when models should and should not be applied is one of the
core reasons we got into an asset bubble in the mid-2000s. Banks were pricing
financial products using models whose assumptions did not hold over the long-
term. They didn't understand how their models were wrong until it was too
late, and it ended up losing them (but ultimately the American taxpayers) a
lot of money. But because the assumption that markets are _always_ rational
and efficient is wrong, it doesn't follow that markets are _never_ rational or
efficient. Markets can be rational and efficient, but it depends on the
relative timeframe and the structure of the market involved.

~~~
lordnacho
>Misunderstanding when models should and should not be applied is one of the
core reasons we got into an asset bubble in the mid-2000s. Banks were pricing
financial products using models whose assumptions did not hold over the long-
term. They didn't understand how their models were wrong until it was too
late, and it ended up losing them (but ultimately the American taxpayers) a
lot of money.

I don't think this is true. Plenty of smart people who worked with various
models knew their data wasn't solid and reflected just a few years of a benign
market, and plenty of people understood the rather obvious idea of a Black
Swan.

The reason they kept at it was systemic: they were paid to sit and cheer the
market up, continue to sell product, and generally not question the business
model.

The people who made a lot of money off the crash tended to be people who were
able to sit out the upswing in some way, without being punished too hard.
Hedge fund managers with either new funds or long track records, like Paulson
and Andrew Lahde.

The crash was always coming. I remember going to a luncheon at GS where that
was the major point. This was in 2006, and they predicted it would start in
2007 and culminate in 2008.

~~~
exelius
It was. Their models made the assumption that debt ratings were accurate, and
they were substituting leveraged mortgage backed securities with AA ratings
for risk-free debt. They also underestimated the effects that a liquidity
crunch would have - any asset model backed by volatile assets assumes
liquidity, but doesn't tell you what will happen in a period of non-liquidity.

Most models assume financial markets are a continuous function, when in
reality markets are _mostly_ continuous with periodic step functions. When you
hit a period with a step function, the market is either being irrational or
correcting prior irrationality. You can't predict these step functions with
any accuracy; though many of the big investment banks knew it was coming a
year or two in advance. But even if you can predict them, there is no good way
to model them.

Goldman Sachs, for all its faults, is run by exceptionally competent people.
They came out of the downturn stronger than they went in. They understand the
models well because they built most of them. But there were plenty of large
market players at Lehman, Merrill, Nationwide, etc. who were ignorant of the
problems until it was too late. These are the people who just did what the
model told them to because it was making them money, and they didn't
understand the risk exposure they really had.

~~~
lordnacho
>Their models made the assumption that debt ratings were accurate, and they
were substituting leveraged mortgage backed securities with AA ratings for
risk-free debt. They also underestimated the effects that a liquidity crunch
would have - any asset model backed by volatile assets assumes liquidity, but
doesn't tell you what will happen in a period of non-liquidity.

Do you think all these guys with fancy degrees did not think about this? Come
on, of course they did. You don't even need to know about any model in
particular to understand that models rest on assumptions. It's a high school
concept they teach you in any TOK class.

The reason GS was able to react is IMO they have a great network. The culture
is geared towards finding out what other people are thinking. They're the only
firm I've been out to dinner with where the guys cared to hear my opinion, in
depth. The same salesguy at another shop reverted back to type.

So they found out through their feedback that many, many people did not think
the models were correct and acted on it.

------
codeflo
Making fun of economists who assume efficient markets is a lot like making fun
of physicists who assume frictionless motion. Or computer scientists who
assume an infinite Turing tape. Simplifying assumptions can be very useful
_if_ you know their limitations.

It seems that in the author's beauty contest game, most people are unable to
analyze this game correctly at the top of their head. Maybe some people don't
even bother and just pick any random number. But assume that this game is
played repeatedly and for real money (like in a stock market). I think people
will notice that low numbers consistently win, which will cause a downward
trend towards the Nash equilibrium in very few iterations.

~~~
vasilipupkin
precisely. In fact, you see it in the markets, even among quantitative Phds,
only a very small fraction beats the market. It's broadly efficient, on long
enough time scales. It's inefficient on extremely short time scales, which is
why HFT works so well.

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bradleyjg
About three quarters of the way down, the author draws these conclusions from
a classic 1980 paper:

    
    
      - there is smart money in the market,
      - the smart money can and is outperforming right now, but that smart money isn't YOU,
      - so sit down and index.
    

I don't mean to be anti-intellectual, the various versions of the EMH and the
responses to them are interesting, important concerns in the study of finance
and economics. But the take away for the vast majority of the public should be
the above. The market may or may not be efficient but you aren't going to beat
it. And even if someone else can, he isn't going to use that ability for your
benefit.

~~~
meric
I think what it means any money can be "smart money"[1], but over a longer
horizon, no money can be consistently smart.

[1] If you work in a company you're well placed than most in judging the value
of the company. Yes there are regulations to prevent you from insider trading,
but no it doesn't mean you can't invest in the company (or short it!) on the
basis you know your colleagues better than others. You, however, have no
advantage over the market over all other forms of investment.

------
aetherson
Has the author of that post every given the Beauty Contest game to the same
group of people three times in a row? What happens then?

~~~
derriz
Indeed the article is poor. His beauty contest results are more plausibly
explained by anchoring bias (start at 2 thirds of 100). EMH is about price
dynamics so a single "run" of the beauty contest says nothing about it. I am
willing to bet a significant amount that after a couple of iterations, the
bids would go to zero.

I simply dont see The "paradox" the author thinks they have discovered. There
is reams of empirical evidence that active fund management is GENERALLY a
losing proposition for savers. Both parties to a trade can end up losers
because trading costs are never zero. If you want to go quickly broke, just
keep blindly buying and selling over and over. Even if you beat the spread,
the fees will swallow your money.

------
codeulike
I've got a tangential question about efficiency that someone might be able to
help with: The perceived wisdom is that capitalist systems result in efficient
companies, because they beat the inefficient ones. So for example we have
Apple making tons of money because they were better at what they were doing
than (most) of their competitors. So the end result of a bunch of competition
is an efficient company ... but how efficient was the process of getting to
that end result? So for example once you count all the failed competitors in a
given market, the bankruptcies, redundancies, people who invested their time
and money in failing businesses. Has anyone measured the overall 'efficiency'
of a competitive system whittling down the competitors to the viable ones? Is
there a name for this concept in economics?

I'm wondering because efficient end result =/= efficient process, and the
process itself must have a cost to society etc.

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lordnacho
When you do find an alpha, it tends to exist for some systemic reason. The
financial system is organized in some way that systematically presents
opportunities to make money. It may have to do with slowness of large players,
information leakage from weak order placement systems, ideological disposition
towards disregarding some phenomenon, etc.

The way to think about it is not some efficient calculating machine, but as an
ecosystem. Can you imagine a tiger saying "hey, there's more prey here than I
need to eat and reproduce. Must be something wrong with the system"? No, he
just eats and shags. Evolution keeps things in check, meaning things don't go
obviously out of whack, but now and again local imbalances occur that can be
exploited. The fact that they are exploited also obscures their existence from
a high level.

------
carsongross
The current and long-running debt and capital gains driven financial asset
market has made everyone insane. If valuations were based on tangible cash
flows (dividends paid out of profits) then the question of how much stocks are
worth becomes far less insanely self-referential.

Real markets work on markup-based pricing and cash flow from profits. See
Steve Keen's work[1]. In a world where the banking system can introduce nearly
infinite leverage into any financial transaction (see student loans) what's
the price of anything?

[1] - [http://www.amazon.com/Debunking-Economics-Revised-
Expanded-D...](http://www.amazon.com/Debunking-Economics-Revised-Expanded-
Dethroned/dp/1848139926)

~~~
JimboOmega
I agree with your complaint, generally.

One thing I often wonder about is the value of Facebook stock. It has
effectively no voting rights (Because of Zuckerberg's control), and I can't
imagine Facebook issuing a dividend... so what rights does it really have? How
do you value something like that?

~~~
carsongross
Exactly. It's the modern world's equivalent of debating the number of angels
capable of dancing on a pinhead. You have these chumps talking about future
cash flows and dividend yield equivalents, all the while the board and
executives march off with the actual cash.

The right thing is to eliminate the tax bias towards capital gains and make
dividends tax-deductible for corporations, so they have incentive to pay
profits out to, you know, the owners. Basically make them act like big LLCs,
which is the fair thing: why should Grandma Jones pay the same corporate rate
as Mitt Romney on her investments in Coca Cola before she sees a dime?

At some point it'll reverse, but it's been a good forty years, so... who
knows?

------
jsprogrammer
> the hypothesis that there is no information in the past history of share
> prices which can be used to predict the future

A belief in that hypothesis strikes me as particularly delusional. The
strongest indicator of what a share price will be at `t+1` is what the share
price is at `t+0`. Why would anyone delude themselves otherwise?

Maybe that would hold true if execution prices are never revealed (not even to
the participants of a trade), but prices are streamed out constantly and are
exactly what traders are interested in (how else can they measure their
'gains' and 'losses'?).

~~~
kpommerenke
A market is weak-form efficient if you cannot use past share prices to predict
the direction of future price changes. Or in other words, if you can't use
past returns to predict future returns. There's no delusion.

~~~
jsprogrammer
Direction of change is a bit different from future price and I don't believe
was considered in this treatment.

------
ScottBurson
It's pretty easy to guess how the EMH got started: economics professors tried
to trade the markets and got their heads handed to them in thin slices. Their
egos, thus battered, created an excuse. What they didn't understand is that
trading is a competitive game of skill: mere intelligence is not sufficient,
any more than it would be if they walked onto a tennis court with Roger
Federer.

~~~
exelius
This is totally wrong; there's very little skill involved in trading. Any
university student with a basic knowledge of calculus can learn all there is
to know about the markets from a skill perspective in a year or less. In fact,
this is exactly why the big investment banks prefer to hire kids fresh out of
college.

Where companies really make a lot of money is on the relationships. Goldman
Sachs doesn't make $500 million off an IPO because they're better at drafting
SEC paperwork than anyone else; they make that money because they have
thousands of clients with money to invest that they can call and convince to
fund the IPO.

~~~
ScottBurson
> This is totally wrong; there's very little skill involved in trading.

Not only are you badly misinformed, you are spreading information that could
encourage someone to risk their money when they don't know what they're doing.

First off, something that requires a university education and a year of full-
time training is not what most people think of when they hear the phrase "very
little skill involved". When a member of the general public tries trading for
the first time, they have far less than even that (and even economics
professors have less of it than they think.)

Secondly, what you're describing is algorithmic trading, not discretionary
trading. I guarantee you that that math whiz fresh out of college is not
allowed to risk significant amounts of money on personal hunches. (I would
guess they don't learn discretionary trading at all; they have their hands
full with the algorithms.) I'm sure there's a lot of infrastructure to ensure
that any strategy they come up with is well back-tested before going live.
Again, the general public (including the professors) isn't doing algo trading
and doesn't have access to that infrastructure and that support system.

Tennis was not the best analog. Trading is more like poker. First, they both
have the property that the more you win, the bigger advantage you have, and
conversely. Second, as they say, if you don't know who the sucker at the table
is, it's you.

~~~
exelius
I can see how what I meant could be taken the wrong way. What I meant is that
you can learn 90% of what you need to know about the mechanics of investment
finance in a year. The rest of your career is spent cultivating relationships
so that people allow you to handle large sums of money for them.

The "skill" involved in trading isn't really that difficult to learn - it's
tradecraft, which you have to learn in any industry. And you're right; the
math whiz fresh out of college doesn't get a ton of money to play with. He
gets a small amount and if he does well, is progressively trusted with more.
The bulk of this type of trading is about risk balancing. Institutional
traders will make more money here simply because they trade using proprietary
platforms that get simply them better prices on securities. The algo guys
optimize the ordering systems such that the prop traders get first pick at
everything.

Trading at high levels (billion dollar positions and above) is a lot like
poker; but the bulk of securities trading is really no different than playing
a video game. I used to know a guy who worked for a big HFT firm, and that's
exactly how he described it. Humans are excellent at pattern recognition, and
so the HFT guys use humans to make decisions about when to get in/out of an
asset. Computer programs show patterns to the analysts, who issue a "yes/no"
decision and who are judged solely on their performance.

But yes, you are also right that mere mortals like us have no chance because
it's not an even playing field. I mean, the algo traders pay millions of
dollars a year to get Reuters feeds 60 seconds early, so by the time news hits
the market, the price has already adjusted. Hell, the trading platforms that
are processing your orders sell access to their incoming order feed, and the
algo traders love to pre-empt your trades to drive the price up.

A more apt definition would be that trading is like poker where the guys with
huge piles of chips also have X-ray vision. And they get to skim the pot even
when they lose. If you have X-ray vision and pot-skimming rights, then yeah,
it's just poker. If you don't, then you should just go play Blackjack (i.e.
buy-and-hold investment where you play against the market as a whole, not any
individual players).

