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Source link: http://archive.mises.org/12775/dont-go-with-the-flow/

Don’t Go with the Flow

May 24, 2010 by

When monetary bureaucrats act, they send shock waves not only through the financial markets but also through investors’ and entrepreneurs’ brains, sending the mass investoriat on another chase toward riches that are but a chimera. FULL ARTICLE by Doug French

{ 11 comments }

Stephen Grossman May 24, 2010 at 10:30 am

Materialism is not science. Man has free will. And many people have been freely
teaching and accepting the idea of inflationism. Man has a brain, of course, but there is
more than material causes.

Paul Marks May 24, 2010 at 1:23 pm

Professor Fama did not even know that a “credit bubble” means that there has been a lot of lending based on credit money expansion (not real savings), he thought that it meant that people have “saved too much”.

Not only is this man not an economist – he should not pass even first year undergraduate economics (or High School economics). Yet, with the utter distortion of the education system, this nonentity is considered a “leading economist” fit to write textbooks.

On Mr Gorssman’s point.

Yes human beings have free will (agency) – that is why we are beings (subjects – not just objects). However, we can only achieve to do what is physically possible.

For example, I may choose to jump one mile up into the air – but I can not actually do this. So my choice is without practical achievement.

I have freedom of choice – not freedom of result.

In economics – I may choose to have an enternal boom financed by credit money expansion with no crash ever.

But my choice will not be achieved in reality.

Todd Geiger May 24, 2010 at 7:00 pm

A great book (imho) exploring this theme from a trader’s viewpoint is “Fooled by Randomness” by Nassim Taleb. Interesting article.

Alex May 24, 2010 at 9:18 pm

The extreme form of the efficient market hypothesis that argues that people act as though they know precisely how markets and the economy works is nonsense.

However, pick a market, any market – say the stock market. The EMH in weak form argues that an individual investor cannot hope (other than by being lucky) to beat the index by picking individual stocks. This is why monkeys throwing darts at stock pages typically outperform the average mutual fund manager!

Of course, a person with access to considerable resources (e.g., insiders of firms) can receive news and process the effect of such news on individual stocks faster than the average person and can thus beat the index by their individual stock picks.

It strikes me that these are useful things for the average individual investor to understand when investing. Hence the above EMH notions are useful.

Guard May 25, 2010 at 2:20 am

Yes, the insiders and fast traders are constantly beating the index, which is another way saying they are stealing from everyone else. Caveat emptor can only be carried so far. At some point, with the rules sufficiently hidden, the operation becomes fraud.

Steven Farrall May 26, 2010 at 5:59 am

Indeed, insider trading is theft, and should be punished as such when revealed. An orderly and honest market is a prerequisite of the EMH.

Peter Surda May 26, 2010 at 6:35 am

Insider trading, just like many other villified situations (e.g. blackmail), is a combination of multiple legal actions, and therefore its illegality cannot be deduced. In some cases, it may constitute a breach of contract. Surprisingly, even the US law seems to agree with me on this, according to wikipedia, insider trading is only illegal if you fail to follow certain procedures.

Mushindo May 25, 2010 at 3:59 am

Given that individuals are not omniscient, it is reasonable to expect that they will form expectations, some of which will will turn out to be false. In a bona fide free market , it is reasonable to expect that their errors will be ‘normally’ distributed – with undershooting errors counterbalancing overshooting errors, leaving market prices as a distillation of all information having been brought to bear in terms of th eEMH. And of course, as people discover their errors and revise their expectaitons with th ebenefit of experience, its reasonable to expect a long term trend towards the mean as it were, as predicted by the EMH. In this respect the EMH and the rational expectations approach have some merit, but neither is a Law of Nature in the same way as, say, the second Law of thermodynamics is.

Both therefore reflect a fuzzy dsort of long-term tendency, and the further from reality are the market expectations, the more powerful will be th edforces that bring it back to reality. This would be reasonably swift in a free market, for as soon as the truth is realised, behaviours adjust immediately. The problem comes in with intervention and the subversion of pricing signals, where such truth is buried for longer. With a cental bank overriding the pricing signals between savings and investment and the goods markets , the errors in expectations made by people are synchronised – no longer are th euncertainties in expectations distributed around some notional most-likely ‘true’ outcome , they are heavily weighted on one side or the other. And its this systemically synchronised error which scotches both the EMH and the REH. Of course, truth will out eventually, but as one wag once obseved: ‘sure the markets are rational and efficient in the long run. But markets can stay irrational for longer than you can stay solvent’.

Finally, for th ephilosophically-minded, I think it was John Allen Paulos who cogently observed that the EMH contains a fundamental and interesting paradox: for it to be true requires that market participants behave AS IF it is not true. And if they behave as if it were true, it will be false.

Steven Farrall May 26, 2010 at 6:14 am

Yes, bad money distorts everything. Especially bad money at the same price as good money. Nevertheless EMH seems to work. Certainly as well as stock picking with its attendent extra costs. And if properly used stops retail investors getting involved in bubbles. Or rather carried away by bubbles, especially bad money induced ones.

I speak from the UK where I run a small financial advisory business and keeping retail investors sane in bubbles is very challenging.

Steven Farrall May 26, 2010 at 6:10 am

Excellent article. But I think you have slightly missed the point with Fama. I feel that his comment on bubble was misunderstood and should be viewed from the perspective of EMH. In other words he doesn’t care about bubbles (in the EMH sense – he probably does care very much in the honest human man sense). Fama’s key contribution is to the risk/reward concept. In other words it seems that, on average, investors require a higher reward for a higher risk. Which is entirely rational. The facts seem to be though, that no-one person knows what this price is, or rather each person has a different price for risks, so the market, with so many participants demonstrates returns based on the average risk. All Fama recommends is that rather than trying to pick stocks or time bubbles why not just try and capture the market rates of return at the lowest cost? Generally this works out best for small investors.

I also like very much your ‘gold under the bed’ remark. This is certainly a very sound way of defending your money against inflation induced by irresponsible fiat money makers.

Of course Gold does not have any income, whereas stocks – equity stakes in real businesses – do. So stocks being a real asset are to some degree an inflation hedge, with income. This last factor is crucial to their success and why investors own them.

In passing I would like to thank you all at the Mises institute for broadening my economic education and confirming many of my own feeling about things. It’s been a great help in my business life.

Alex May 26, 2010 at 2:39 pm

“Finally, for th ephilosophically-minded, I think it was John Allen Paulos who cogently observed that the EMH contains a fundamental and interesting paradox: for it to be true requires that market participants behave AS IF it is not true. And if they behave as if it were true, it will be false.”

I don’t think the above is correct. Again considering the EMH that argues that a market prices in all available information, this in no way says that current market prices are precisely what they should be according to EMH. Consider the effect of new information that is expected to affect the future profitability of a company and hence the company’s current stock price. Suppose really, really good analysis predicts that this new information will affect the company’s future profits such that its stock should be currently worth $10 per share.

First of all, new information always has an uncertain effect on the value of a stock, even if the best analysis is utilized. Only the future unfolding of events will show what the true impact on the stock price should have been when the information became available to market participants.

Since different rational investors have different attitudes toward risk, some investors will think that $10 per share is too high a current price, while risk-lover types will think $10 per share is too low. As a consequence, even if the most efficient (best analytical) processing of the new information yields an expected value of the stock of $10, there will still be trading of this stock at that price (that is, even if everyone believes in the EMH, there will still be action in the market). In this example, the risk averse will sell at $10 to the risk lovers. Depending upon the distribution of attitudes toward risk in the market, the stock price could rise above $10 or settle at below $10 per share, even though everyone may agree that its expected value is $10.

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