I loved this comment from my friend and co-author Howard Reed on the blog this morning:
As someone who thinks that the financial industry is maybe 95% composed of con-men and hustlers, the EMH has a certain appeal, as it implies that the active fund managers are charlatans; no-one can consistently beat the market.
But on the other hand, it also implies that anyone investing in an actively managed fund is completely irrational (assuming their goal is income maximisation) because they could achieve just as good an expected gross return on their investment with lower costs (and therefore higher net returns) if they were to move their funds from active management to an index tracker.
But, if huge proportions of investors are irrational, there's no reason for the Efficient Market Hypothesis (which relies on rational investors) to hold. And therefore the whole theory is built on a paradox — and hence unreliable.
Such is the irrationality of economics, if only it realised. Howard does.
Thanks for reading this post.
You can share this post on social media of your choice by clicking these icons:
There are links to this blog's glossary in the above post that explain technical terms used in it. Follow them for more explanations.
You can subscribe to this blog's daily email here.
And if you would like to support this blog you can, here:
Buy me a coffee!
This is incorrect. The efficient market hypothesis does not assume that market participants are perfectly rational, but that they have rational expectations of the future performance of their investment based on the information available to them. Nobody would claim the assumption is always true; it is however true for some markets at some times.
Some strong forms of the EMH are questionable, but there is good evidence for its basic claim: there is a plethora of research showing that an index (or randomly chosen portfolio) easily beats the majority of fund managers (at least in relation to markets that are reasonably liquid and where information is generally available to all). There is also research showing that this is not the case where the assumption does not hold true (e.g. Asian markets in the 90s).
There is nothing right wing about this claim or its conclusion, and you are in danger of tilting at windmills based more on the words “efficient market” than actually reading Farma’s work. Indeed, measures to encourage investors and pension funds into index tracking funds would be both economically efficient and progressive (i.e. by reducing rent-seeking behaviour by fund managers). To be fair, most of the times one reads about the EMH it is being cited with a political agenda of one shape or other; the Wikipedia article is astonishingly ignorant in this respect.
You do yourself no credit by moderating posts that politely point out your errors.
I do not accept I have made errors
I am arguing with a pernicious system
I respect commentators but nothing requires me to agree to their hegemonic thinking that facilitates abuse of people
I was tilting at the use made of the work, not the work
It seems to me fairly clear that Eugene Fama believes that the EMH applies to all markets at all times. For example, he’s on the record as saying he believes there is no such thing as an asset bubble.
Ciaran, if EMH had been a scientific theory then by now it would by have ended up in history’s dustbin….
What sort of theory, by your own confession above, works only part of the time?
http://robertnielsen21.wordpress.com/2012/08/09/the-nonsense-of-the-efficient-market-hypothesis/
http://unlearningeconomics.wordpress.com/2012/10/22/debunking-economics-part-xiii-alternatives-to-the-emh/
Now if you would like to discuss the numerous efforts made to rig the financial markets that would be an entirely different matter!
Beautifully put by Howard. Surely not another example of an emporor of neo-liberal econimics being shown to have no clothes?
But might there also be another explanation? I quote from the last sentence of your blog on this topic from yesterday (which various people took issue with): ‘Yes, the EMH says you can’t beat the market. Maybe that’s true. But no one listened pre 2008 and I don’t think anyone is listening now.’
If we changed ‘no one listened/is listening’ to ‘relatively few’ and then added in ‘and of those that did/do many – for whatever reason – don’t believe the EMH hypothesis’ then it seems to me that we’d probably be pretty close to reality.
This is completely wrong.
The value of anything at any moment is its market price. Everything else is noise and opinion. Why it is unreliable to say that the average of a large number of people’s beliefs is likely, on average, to be more accurate than a single person’s opinion?
I believe it has been more or less proven that if, for example, you have a large jar of sweets and a large number of people estimating how many sweets there are in a jar, you will end up with a very accurate estimate, even though all the individual estimates will vary wildly and none of the estimates may themselves be accurate.
I don’t see the difference between that proven principle and EMH.
Price is not value
You miss he pint between the two, entirely
Not sure about the ‘wisdom of crowds’ hypothesis (which I think is what Roger is talking about here). I would be pleased if it were true as it would provide a really strong theoretical underpinning for democracy (“the people know best”) but it seems to ignore the role of specialist knowledge. If you were feeling unwell and wanted a medical diagnosis, which would be the best option: do an opinion poll ONI the public to find out what’s wrong with you, or visit a doctor? According to Roger the GP diagnosis will be less reliable than the balance of public opinion (most of whom are not medical specialists and have no medical training). That just seems unlikely to me.
I didn’t read his post in that way – I read it as: if you take an average of “a large number of people’s beliefs” (ie. the beliefs of a handful of people, mostly specialists, in relation to lots of different stocks) you are likely to get to a more accurate price than if you rely on one person’s beliefs about one stock?
AB is correct. The wisdom of crowds is rubbish if you are trying to work out a “fact” like a medical diagnosis or when an event in history occurred. But if what you are doing is making a prediction or estimating something uncertain – such as who will win an election, how many sweets are there in a jar, how much is Vodafone worth etc – a large sample of uninformed people will have a smaller margin of error than a single, informed person.
The answer to that is ‘maybe’
In my opinion
Crowds also make mistakes
History is littered with the evidence
But it’s entirely possible that the process of analysing the potential future performance of a company – which is what company analysts in the finance sector do (in some cases being paid large amounts to do so) is more akin to a medical diagnosis than a guess about how many sweets are in a jar. And if company analysis is a specialised high-skilled task then it seems reasonable that ‘insiders’ in the finance industry may know more than Joe Public. Which may provide some rationale for actively managed funds. (I stress ‘may’ here: from talking to some people in the finance sector I’m far from sure that they really know what they’re doing at all!)
This FT article is interesting.
http://www.ft.com/cms/s/0/78175d1e-34c7-11e3-8148-00144feab7de.html?siteedition=uk#axzz2hsIoOrid
In particular, the comment by Martin Wolf linking to Grossman and Stiglitz (http://www.math.ku…ssmanStiglitz.pdf).
For gamblers to win there must always be losers. The government, by urging us to invest in pensions, aid and abet their friends, the con-men and hustlers of the financial industry, who are always the winners. Us poor suckers who have invested in pensions are the losers. We are encouraged to pile in with tax relief on pension contributions to allow the governments friends in the city to continue with the swindle. We are told there is a pension crisis looming because we are living longer. You only have to do the sums on the returns you get on an annuity to realize it is a swindle. You would be better off if you used the bank of “under bed” but of course that is not allowed.
You might be interested in this. https://www.youtube.com/watch?v=HiEqPzpMA9M&feature=player_embedded
David Lucas
Great rap – I’ve suggested, in a previous blog, that Richard should do something similar! This young man manages to get all the issues across, with young people around like him there is hope. I’m in my early 50’s and now feel my generation has let young people down-many of my age swallowed Thatcher’s guff, lined their wallets and danced to the greed-is-good tune and look where we are.
Thanks for posting this, it cheered me up a great deal!
Excellent! paradox is what underlies much of economic thinking where one part of the thinking completely contradicts another. The late physicist, David Bohm, spent much time writing about the paradoxical nature of thought and how it undermines our efforts to solve ‘problems’; this is because many things aren’t problems, they are paradoxes.
In my view it’s worth reading this: http://dialog.over-blog.com/pages/the-problem-and-the-paradox-david-bohm-on-dialogue-8393688.html
How can markets these days be referred to as ‘efficient’ when we know they are rigged and there is no genuine ‘price discovery’? Thoughts please, as well as your definitions of ‘efficiency’ in this context!
An interesting paradox but its main fault is in its assumption that passively managed funds have been available to investors.
Passively managed funds are a relatively new invention and are growing rapidly. As “rational” investors recognise that active management is an expensive way of receiving “average” performance.