> the market is not as efficient as it is supposed to be
I have a recent business degree, but not finance or econ. In school we were strictly taught the market is efficient and I fully believed that. But I've seen online and discussed in person a (seemingly) growing idea that markets are not in fact efficient at all.
Are there any economists/finance people that can shed light on this? Are these new ideas gaining traction, or old ideas just sticking around?
Check out the book "How Markets Fail" for a discussion on how the efficient market hypothesis gained popularity (part 1) and a discussion of the many ways that real markets do not maintain the preconditions for markets to be efficient.
In particular, the precondition that Adam Smith stated was that increasing production required linearly increased costs. However, this is frequently not the case (utilities, railroads, software, social media networks, etc.). Also, markets require a certain minimum number of producers (and consumers) in order to remain efficient. Consolidation can reduce the number of producers below the level that meets the precondition of efficiency, and then barriers to entry to prevent newcomers from joining the market.
As far as efficient market theory applied to the stock market, I've always thought that efficient market theory was trivially disprovable: did all companies in the US lose 20% of their value all at the same time this past Nov - Dec, in the same season that they are selling all their inventory during the holiday season? And then regain 10% of it all at the same time the next month? Did Apple lose 50% of its value from between July and December, despite the fact that its revenues, costs, dividends, assets, people-capital, know-how, brand, consumer sentiment, etc. remained roughly the same? Compare to, say, PG&E during the same period.
John Cassidy's "How Markets Fail" is a must-read IMHO. I went through 4 years of an economics degree at a top tier university (top 5 globally in Econ), and Cassidy's book just happened to be the weekly assigned reading for a class my last semester.
Everything then made sense. All the inconsistencies you hear about economics, with one camp saying one idea and another talking about something totally different, both passing it off as consensus, fit into place.
TLDR: Cassidy's book is in 2 parts. The first part, he constructs the classical/rational model of economics through intellectual history. The second part, he deconstructs, drawing from all the critiques of inefficiency, both behavioral and mathematical. (Some of the most fascinating aspects are the beautiful mathematical models that can't be solved). It's all well written prose, no need to have a pen and calculator to follow along.
The title is misleading IMHO, because it seems to be a populist polemical. It's not. It should be called something like "A Brief History of Economics", echoing Hawkin's Brief History of Time.
FWIW, the efficient market hypothesis has very little to do with the efficiency (or absence thereof) of market based economies, efficient production, etc.
I think maybe a better question is not if markets are fully efficient, but if markets are more efficient than the alternatives. I read the Cassidy book years ago, so I might be misremembering, but I don't think that was something he spent much time discussing. I don’t think many would argue that markets can't fail and aren't fully efficient - he spent the entire book demonstrating that.
The idea that regulators have the ability to design, implement, and maintain laws that correct or protect from market failures without producing unintended consequences, perverse incentives, significant costs, or market distortions more severe than the original market failure was not sufficiently addressed, from what I remember. Despite their problems, markets tend to be dynamic, adaptive, and innovative, while regulations tend to be rigid, slow, and reactionary. I don't know what the answer to market failure is, but I found the book unsatisfactory in that regard.
Cassidy spends plenty of time stating that regulations are often bad for markets, and he spells out clearly which types of markets need to be regulated: specifically markets with negative spillovers, mono/oligopolies, and the financial industry because of its unique ability to impact money supply.
He goes to GREAT lengths to talk about all of the potential pitfalls and problems with placing regulations on these industries. And he even gives many examples of times in the past where things did and did not work.
Sure, you can get a positive outcome from the wrong approach. But examples are probably the best thing we can look to...
I think there are a few good responses to the question of "are markets efficient?".
1) Markets are efficient enough in that you generally don't see any real big arbitrage opportunities. Small ones will always be present, and as is often pointed out its not worth the big players time to search them out and capitalize.
A trader also sees this as evidenced by the fact that we are using more and more data and ever increasingly complicated math to eek out smaller and smaller chunks of alpha.
2) different people have different ideas as to what the correct price actually is.
Consider a company that is continually losing money.
- Fundamental analysts will value this as a poor company due to its future cash flows dwindling. They may consider this a short opportunity
- Merger Arb folks may bid up this up as a potential merger target thus raising the price.
- ETF's tracking an index just don't care, they'll buy the company in proportion to its index weight.
- Stat arb folks will be agnostic to price and only compare it to a peer that they feel it will trade in relation ship with, these people will be both long and short this company at different times, often unrelated to what its price currently is.
3) Physics often uses the simplifying assumption of no friction to make things easier. The efficient market hypothesis works under the assumption that everyone knows about news immediately and has time to react. Some investors react in micro seconds, some in weeks. Both affect the price
Well in the UK I have as a amateur investor taken advantage of arbitrage in the last few years. One on a big trust Witan that had gone out to a much bigger discount than normal due to a stock overhang caused by a forced sale. The other was Electra private equity which was on a huge discount.
It's only an arb if your net exposure is zero. If you want an arb, look at Hansa. You can buy their trust and sell an underlying porfolio which, if you do it right, should come out to very close to zero exposure. But most CEFs aren't selling at a discount because of liquidity, they are just shit (if the manager is decent, they should buy back shares to close the discount).
The market can stay irrational longer than you can stay solvent.
Efficient market theory is mostly used to justify deregulation, to protect the profits of the big players who can throw the most weight around.
Some economists support this (perhaps because their paychecks depend on it, or they were brainwashed at the University of Chicago where the movement was strongest). But I doubt most do, especially these days, so soon after the reminder of the Great Recesssion, 80 years after the Great Depression taught the initial lessons. But Keynes got boring for some I guess, and the allure of the "totally rational human" was clearly too great for some, and attractive to lobbyists.
Isn't the modern interpretation of Keynes a complete bastardization of what he was actually teaching?
AFAIK, Keynes claimed that the market is more efficient than not. But he was decidedly not a believer of the efficient market hypothesis! Further, he was mostly concerned with money supply and risk-free government bonds.
Sometime between the 60s and the 80s, Keynes got associated with Supply-Side Economics and Laissez Faires (which from my understanding Keynes was completely against).
Also, when Keynes was writing -- FIRE (Finance, Insurance, and Real Estate) amounted to about 5% of the U.S. economy. Now it amounts to more than 30%. So, ideas that weren't concerned with those markets probably need to be concerned with them now.
I'm honestly baffled why anyone would take "markets are efficient" seriously.
It seems such an obviously rhetorical (i.e. politically expedient, not fact-based) narrative intended to sell the idea that markets are the very best of all possible ways to organise everything - in spite of all the centuries of historical evidence that markets consistently run in an irrational bubble-driven boom-bust cycle with almost insanely destructive opportunity and recovery costs.
What “markets are efficient” means is really that you can’t make more money on the stock market than average unless you put the same time and brain power to it that hedge fund people do, and even then you can only make about as much money as hedge fund traders do. (Assuming a few things, like that you’re only trading based on public knowledge)
The logic is this: if this were not the case, then some of those very smart hedge fund people were take advantage of this strategy, making that strategy become the average that everyone wants to beat.
The Efficient Market Hypothesis states that every asset is fairly priced, because anything that CAN be known about it has been ALREADY factored into the calculation of price.
That's like walking down the street, seeing $20 and thinking, "Nah, if there was money on the ground someone would have picked it up ALREADY".
Markets trend towards Efficiency, they are not in themselves efficient
That's actually not what the efficient market hypothesis (EMH) postulates. The EMH does not state that it's impossible to find opportunities to make a better-than-market return. It states that it's impossible to predict those opportunities.
In other words, the EMH does not preclude $20 bills from lying on the street. It does imply that, in an idealized market which is informationally efficient, you cannot predict where people are dropping $20 bills around the city.
Your example is one of the most common mis-analogies of what the EMH states. But in point of fact, if the EMH precluded any better-than-market returns, it would not be possible to have a market since you'd have no risk or volatility.
You could make a similar comparison with evolution -- if the jungle is so competitive, how does the monkey find any food? The answer is that there is fruit available, but the monkey has to invest energy and expertise (both now and via billions of years of evolution) to extract it. The bigger the fruit, the more difficult to get it.
If you believe the market is 100% efficient, then it follows it always has been this way. Do you really think the market is equally efficient as it was a 100 years ago? If not, then it follows that market efficiency is a gradient, and gets more efficient over time. I do not believe the market will ever hit 100% perfect efficiency. There is room for improvement and room for longer term alpha.
Another argument against EMH is to assume it is true. Market wages for quants and hedge fund employees would reflect their true value. But wages for quants are a lot higher than the cost of using a random number generator. If all trading success can be attributed to luck or chance, it would make no economic sense to hire expensive quants, hence EMH being true leads to a contradiction.
I do believe in a no free lunch theorem for market pricing. Averaged over all traders and all stocks and all strategies, there is no perfect approach that beats the market consistently. But that is of little practical value (in inference and search the no free lunch holds, but we can still use prior information to limit search ranges, focus on the profitable markets, and use approaches that worked on similar problems).
I am tempted to ask which school and truly in the post crisis era? In my econ podcasts they keep lamenting how things like this are still thaught, but I was somewhat incredulous. I studied econ in the early aughts and there was more behavioral, industrial and institutional economics than macro in my program. That was long before the crisis and still looks like the proper mix.
And then on the question. Perfect information is false and there are degrees in the definition of how efficient markets are, with the most common one approximating 'somewhat' on the not too short timescale. Mileage varies between commodities, stocks, your staple teaching example of the market for used cars (lemons) going towards the more micro models with network effects etc.
Institutional economics will teach you that no market functions without surrounding institutional arrangements and that there is some relationship between the nature of the product and the optimal 'institutional burden' (my words). Mechanism design is the subject where they try to design optimally structured markets.
Economics is awesome and anyone teaching only perfect information even to undergrads or business students should be fired. Ceterum censeo
Such and utter BS. There is so much science in econ. Just look at some of the work of the nobel laureates. Gary Becker treating social relationships as outcomes of economic relations. Great and provacative work. Ostrom on tragedy of the commons and solutions? That has properly changed the way we treat things like fishery, with more sustainable outcomes when applied correctly. Had we learned more of Douglas North, we wouldn't have so much kleptocracy in eastern Europe in the post-USSR period. Fama in finance, etc. etc.
Too easy to dismiss that much work. And don't blame economists for the crisis. That's politics. There are a lot more lawyers in politics than economists...
We don't discredit the whole of psychological science for the failures of a load of social pop-psychologists. Perhaps, perhaps we can discredit the whole of nutritional science. And even there I'd say we have learned some but that the financial incentives are so biased against proper learning that it's hard to blame the field as a whole.
Sane people do discredit most of psychological science. BTW, they're a real science where people could find an answer, and economics almost entirely isn't.
Probably the best piece of economics I've seen is Coase's theorem. While we base our laws on this idea, it's still a shaggy dog story, and basing it on dialectical materialism, the divine right of kings or Schmitt's friend/enemy principle would work just as well. Citation: places which never heard of Coase's theorem work/worked just as well.
To me that's hiding another question of whether or not it's worthwhile. Like when we ask if something is or isn't art, or if writing software is or isn't engineering. There shouldn't be any link between saying economics is or isn't a science and giving it credit.
Efficiency doesn’t have to imply perfect information. (There are many forms) Just that probabilities are baked into the price so that there are no easy arbs.
Are you certain you remember all of your schooling? Any basic finance class will cover the efficient market hypothesis, but also cover exceptions and temporary violations. This is standard course content and hasn't changed significantly in decades.
No industry practitioner actually believe in strong EMH. Otherwise they would be doing something else. If the market was efficient, then no one, and I mean no one, would be able to achieve a higher Sharpe ratio than anyone else. A higher return would always imply higher risk. This is clearly not true, and the Sharpe ratio of different funds and investments has a high variance.
Maybe you can say that weak EMH is true, that is, that the market is mostly efficient (and I believe that, as a professional market practitioner), but there will always be opportunities to make superior risk adjusted returns giving enough skill and wit.
Perfect markets are efficient. There are no perfect markets because the participants are not all perfectly rational or in possession of all relevant, complete and correct information.
Hypothesis is the key word. It's not a law, or a tested theory.
Also, it's predicated on all participants having perfect info, which doesn't happen in the real world.
Is it useful? Mostly no, in my opinion, other than realizing that when my own idea of valuation differs from the market's, it's usually because I'm missing something.
All models are flawed. The question is not whether the market is efficient, but rather if it is useful to model the market as efficient for the purposes of economic research. Such a model does seem to work well in a lot of cases.
The EMH has been losing some steam because it doesn't match the data. In the last couple decades there has been a lot of data crunching like this, and academics have found these same factors. This study confirms those results with more and older data.
People have come up with two classes of explanations, touched on in the article. One is human behavioral factors and cognitive biases, the other is structural biases in the economy, like investment managers being more incentivized to avoid relative losses than to make absolute gains.
The market model is a gross simplification of reality. The basic model doesn't incorporate irrational decision-makers, data asymmetries, externalities, etc.
There is a lot of 'probably' going on here. He structures his entire P=NP argument on the basis that most computer scientists believe it to be false. That's fairly weak.
He has shown that markets are only efficient if P=NP, but that doesn't say much about whether they are therefore inefficient.
"In short, if P≠NP, then the market cannot be efficient for very long because the ability of investorsto check all strategies will be quickly overwhelmed by the exponential number of possible strategies there are to check."
He also states this, but even an overwhelming amount of strategies can be condensed into algorithms that makes 99% of them useless. See the game of chess for similar ideas. 99% of the possible moves are useless, so it seems as if there are an exponential amount of good moves when only a fraction are viable. Chess is NP, but still partially solvable under P conditions. I believe the market is like this too.
> In school we were strictly taught the market is efficient and I fully believed that. But I've seen online and discussed in person a (seemingly) growing idea that markets are not in fact efficient at all.
I can tell pretty much everything I need to know about a person based on which one of these ideas they would say or defend.
Always lots of new ideas and theories that hope to reduce the participants in a market down to an explainable behavior.
But there are lots of ways to extract value from a market, which is more important than the debate around "already 'efficient' or not".
I have a recent business degree, but not finance or econ. In school we were strictly taught the market is efficient and I fully believed that. But I've seen online and discussed in person a (seemingly) growing idea that markets are not in fact efficient at all.
Are there any economists/finance people that can shed light on this? Are these new ideas gaining traction, or old ideas just sticking around?