An old economics joke goes like this. A person is walking along and says to an economist, look, there is a $20 bill on the sidewalk. The economist disputes it without looking, on grounds that if it were there, someone else would have already picked it up. It’s funny but it is also not far from describing a widely held that financial asset markets always fully reflect all available and relevant information, and that adjustment to new information is virtually instantaneous. FULL ARTICLE
Source link: http://archive.mises.org/6893/are-profits-purely-random/
Are Profits Purely Random?
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This take is very interesting, but Im not sure the EMH should be dismissed so readily. The main point underscored by the EMH has been de-emphasised in this article: the key point is that the EMH says that you can’t CONSISTENTLY beat the market, no matter how smart your technique or analysis might be. That word is the very essence of the hypothesis. The EMH does not necessarily prescribe a passive approach either – new information emerges all the time, and in its weak form, all the EMH says is that the moment anyone with new information acts on it, the new information has by definition been brought to bear on the price of the stock concerned. It may well be possible for someone to discover an algorithm or a new analysis of historical information that enables him to predict a stock’s performance at better than random dart throwing, or index-matched market tracking, and the EMH does not deny that possibility. The point is that as soon as this newly discovered prediction technique is exercised through actual buy/sell decisions, and as its success prompts others to emulate it, those trading actions themselves will have the effect of neutralising the technique’s effectiveness, and the newly-discovered history/predicted price relationship is subverted.
The EMH does not disavow error either – indeed it explicitly accommodates it. every investor brings only a partial cut of the total potential amount of information about the stock to the market, and acts on only the incomplete information at his disposal – which might well include some inaccuracies, and unsubstantiated opinion. Aggregated across the market, errors on either side of the ‘truth’ ( whatever that is) tend to cancel out leaving the actual price resulting from all these trades as the net ‘distillation’ of all the information on which all the market participants have acted on, up until the last trade before this moment.
ON this take, of course, all new information must by definition start as ‘insider’ information (OOH Horrors!). After all, when new information emerges anywhere, the very first trade made with awareness of this new information is the very trade that brings the new info to bear on the price, and hence that trader has acted on information that was not available to any prior trader. Let the SEC get their minds around that!
with that said, I dont hold to the EMH as a matter of dogma, always and everywhere true, but like, say, marginal or utility analysis, it is a helpful little thinking tool if its not turned into a religion – its an imnperfect and unpredictable world, but lots of people make decisions based on past stock performance, others look at projected returns, and all these different investor approaches will inevitably rumble the ‘purity’ of the EMH in its strong form. But it does have some applicability to some fuzzy degree. after all, (proof is in the pudding) most portfolio managers use both technical analysts ( those who disavow the EMH and eschew fundamentals research and contend that past price movements are what yields clues to the future performance) and ‘fundamentals’ analysts who are usually EMH proponents to a man. And if they use both, its clearly because neither has the full answer by itself ( ha ha, I hear you say, spoken like a true economist…..). Benoit Mandelbrot ( In his book ‘the (mis) behaviour of markets’) has gone as far as teasing out two components in the factors moving stock prices: there is one element which is genuinely unpredictable and is driven by the emergence of fresh information, and another element which does allow the force of historical price movements to influence further price movements. The relative weight of these influences changes from stock to stock and time to time, but they are both very much there. Modelling both of these influences as separate variables permits , if not any hard ability to predict future prices, at least a more robust appreciation of risk. Whooops, I digress.
INterestingly, one John Allen Paulos in his very entertaining little book ‘a mathematician plays the market ( and loses his shirt)’, presents the EMH as a paradox worthy of Zeno: If you want the full rationale , read the book, but the upshot is this:
The EMH will be true if, and only if, the market participants all behave AS IF it is NOT true. And if all market participants behave as if the EMH is true, then it will be fouind to be false.
wrap your head around that one!
David
Demand for investment outlets operates the same as consumer demand in that high returns send signals that draw investors who bid up the price, thereby lowering the ROI. The market works the same way in the other direction: onsumer demand draws ever more suppliers with the result that prices and profits decline. This is why you should ignore those e-mails that promise 200% or some other ridiculous ROI. By the time the boiler room’s e-mail has gotten to schmucks like you and me, it’s a safe bet that the opportunity for 200% ROI is long past.
Thus, like David, I don’t hold to the ‘hard’ version of EMT, but it provides a useful framework. Malkiel knows his stuff and has run the numbers again and again. It is a much more rare occurrence than people think to beat the returns offered by simply buying and holding a large basket of stocks. This suggests a degree of efficiency in the market for investment dollars.
One quote from the article I don’t agree with is below.
“EMH proponents even maintain that a dart-throwing chimpanzee can be a good substitute for entrepreneurial activity. ”
I don’t think Malkiel or anyone else is confusing dart throwing with entrepreneurial activity. If I build a better mousetrap and benefits society and an investor profits by it, who is the entrepreneur? Me or the investor? Or both?
What if the investor has a team of researchers and invests in thousands of startup companies. Most likely he will follow the market for the risk he is taking with the money. Again, its tough for me to call a blind investor an entrepreneur. Or at the very least is an entrepreneur for supplying capital to 1000′s of companies but should not be “credited” with all the value the indivdual entrepreneurs get credited with.
By EMH, this master investor on average will keep the value he provides which is the excess return over and above the price of the market risk of the capital invested.
Actually, criticizing EMH is donkey’s work for a scholar. A colloquial translation of it – don’t expect past performance to be reflective of future performance – is sound advice for the typical investor, and the consistent urgings of EMH proponents for investors to put their money in an index fund has proven to be good investment advice on balance.
The only public notice that a critic of EMH would ever get is from chartists and other investment advisors whose careers are built upon the denial of it. The fact that EMH serves an investor-protection purpose makes it “Babbitry” in the good sense.
Dr. Shostak has really done a service in criticizing it, nevertheless. Perhaps future scholars will treat EMH as a beneficient myth, one that isn’t accurate in terms of its reasoning but nevertheless keeps the believers in it out of tempting trouble – somewhat like, “Providence [eventually] helps those who help themselves.”
Daniel Ryan has hit it square on the head here.
Dr. Shostak has a longer article on this subject that you can read on the Mises site if you go to Publications, E-books and select Authors. The article is “InDefense of Fundamental Analysis: A Critique of the Efficient Market Hypothesis.” Or this link might work.
I think the longer article is more convincing. He also includes some investing advice, such as that capital intensive industries will do well in the beginning of a boom, consumer industries in the latter periods. Austrians should know to get out of the stock market when it sets new records.
A party of economists was climbing in the Alps . After several hours they became hopelessly lost. One of them studied the map for some time, turning it up and down, sighting on distant landmarks, consulting his compass, and finally the sun.
Finally he said, ‘ OK see that big mountain over there?’ ‘Yes’, answered the others eagerly. ‘Well, according to the map, we’re standing on top of it.
This is a very bad article. The text starts by stating that the efficiency market hypothesis implies that profits are random. This is not true and shows that the author does not know what the EMH actually says and consequently should not be writing about it. He continues by saying that the EMH destroys fundamental analysis. No, no, no. The EMH holds precisely because investors are trying to use all the information to gain excess returns. The EMH implies that an investor using fundamental analysis will not be able to systematically beat the market. But if nobody was using technical and fundamental analysis then it would be possible to systematically beat the market, i.e., the EMH would not hold. He goes on saying that EMH proponents suggest that a dart-throwing chimpanzee can be a good substitute for entrepreneurial activity. Nobody ever has claimed that a monkey can run a business. Throughout the article the author fails to see the difference between entrepreneurial activity and choosing a portfolio of financial assets. And he seems to ignore that in fact a famous finance newspaper every year used to ask three professional investors to select one portfolio, and compare the return to that of a portfolio chosen by a monkey throwing darts to the newspaper pages. It turned out that some years the portfolio chosen by the monkey would do better and some it would do worse. The author keeps on his view that the EMH implies passivity and resignation from an active search of opportunities. Similarly, it is precisely the fact that entrepreneurs look for opportunities what makes them disappear. Rothbard quote misses the point that the time spent by the entrepreneur is one of the factors of production, and that’s what eliminates profit opportunities when all opportunity costs are taken into account (Economics 101, Mr Rothbard). And Mr Mises, investments, financial or productive, have different degrees of risk, and the fact that people is risk averse makes safer investments less rewarding in expectation. The risk/expected return relatiosnhip is an undeniable empirical fact. Investments are uncertain and investors don’t just try to obtain the highest profit while ignoring the risks involved.
Anna many thanks for your interesting post. Unfortunately we have to agree to disagree.
All the best,
Frank Shostak
Dear Mr Shostak, your reply is rather laconic. Could you please explain using logical arguments or empirical evidence (rather than quoting statements from a famous Austrian economist) what exactly is wrong with my remarks?
Dear Anna,
The point of the EMH is that the market is so efficient – prices move so quickly when new information does arise – that no one can consistently buy or sell quickly enough to benefit. This is the reason, according to EMH, why if one makes profit this should be seen as random. Hence the logic for the index funds – which operates on the principle that most investors would be better off in an index fund rather than investing in an actively managed equity mutual fund. According to Paul Samuelson,
“Chance alone would be as good a method of selection as anything else†(A Random Walk Down Wall Street, p 190).
All the best,
Frank Shostak
Anna: “The EMH holds precisely because investors are trying to use all the information to gain excess returns.”
It’s not true that all investors use fundamental analysis. Most follow the advice of experts. Others use technical analysis, ie., chart reading. Those who use fundamental analysis are a small minority. But for the sake of argument, let’s say that every investor used fundamental analysis in picking stocks. For EMH to be true, every investor would need to know the same things. No one could know more than others or that person would have an advantage and could earn higher returns.
The EMH is just an outgrowth of the perfect competition model in which economists assume that every consumer and producer has perfect knowledge, and all have the same knowledge, so that producers can compete only on price.
Anna: “Throughout the article the author fails to see the difference between entrepreneurial activity and choosing a portfolio of financial assets.”
The article, and EMH, are about investing, or picking a portfolio. What does entrepreneural activity have to do with it? You lost me there. Unless you’re suggesting that the role of the investor is to discovere the best entrepreneurs?
Anna: “And he seems to ignore that in fact a famous finance newspaper every year used to ask three professional investors to select one portfolio, and compare the return to that of a portfolio chosen by a monkey throwing darts to the newspaper pages.”
That would be the Wall Street Journal. I used to follow those competitions closely. But I can see why most pros couldn’t beat the monkeys: they follow Keynesian economics. Austrian trained investment advisors should have a huge advantage. There just don’t seem to be many of them.
BTW, I have seen research from the University of Chicago that does show that value investing consistently beats the market over the long haul. The vast majority of pros follow the growth style of investing, which does well in a bull market but causes you to lose your short in a bear market. I think it’s the growth investors who couldn’t beat the monkeys, not the value investors.
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