The Efficient Market Theory Hoax

You may have heard of something called the Efficient Market Theory.  If you did, it was almost certainly in a negative context, some writer or blogger excoriating those egghead finance professors for confusing the world with NYSE-floor their crazy and dismal theories. This is a rant mostly heard from the advocates of investing in individual stocks, but is also found occasionally in the arguments of those in favor of active funds over passive (index) funds and market timing over passive asset allocation.

Apparently, this poisonous heresy has been spread by overly educated academics near and wide for decades.  They convince their innocent students that it is categorically impossible to make money picking stocks, that anybody who does anything other than buy an index fund is a fool.  It’s a viewpoint that is not just wrong, it’s dismally pessimistic and, let’s face it, simply un-American.

Funny thing, though. I actually took finance courses from those egghead professors in college and B-school.  I don’t remember an “Efficient Market Theory” being discussed.  I still have my old textbooks.  No index entry for it.  It does appear in the index for Burton Malkiel’s A Random Walk Down Wall Street, a million-seller often described as the chief popularizer of this apostasy. That entry reads “efficient-market theory, see random-walk theory.”  And if you look that up you find out that Malkiel isn’t a true believer after all. “I still worry about accepting all the tenets of efficient-market theory, in part because the theory rests on several fragile assumptions.”

Now, I do remember that in some of those finance classes I took there was a lot of talk about the Efficient Markets Hypothesis, or EMH.  That’s in the index of most of the old textbooks.  It may sound trivial, but the difference between a hypothesis and a theory is, at least in this case, quite significant.

EMH was conceived as a null hypothesis in the 1950s and 60s. On the slim chance that you are unfamiliar with the term, I will summarize. A null hypothesis is a reasonable, obvious, and often naive interpretation of data to explain what is going on.  You invent it as the alternative to the new clever theory you are trying to test.  “The Earth is flat” and “heavier objects fall faster than lighter ones” are examples of great null hypotheses from history.  A key thing to remember about null hypotheses is that they do not need to make sense in the big picture, they exist only as simple explanations that can be disproven to justify more complex ones.  The Earth is flat has a lot of issues as a theory, e.g. what happens at the edge and how the objects in the sky work, but it is largely consistent with ordinary daily experience.

EMH states that stock prices reflect all available information at any given point in time.  Stock prices instantly change to reflect new information as it arrives and those changes will by definition be unpredictable and random, because anything that could have been anticipated would have already been baked into the previous price. As a result, you cannot make money picking stocks.

It’s not clear that when EMH was born any serious researcher believed it as a theory of how the real world worked.  It was thought up as a straw man against which it could be proved that you could indeed make money picking stocks, particularly with some “technical” and “chartist” theories that were then popular and, with the advent of computers, could for the first time be tested methodically.

But when the professors used the computers to look at the data, EMH turned  out to be very very hard to defeat with statistical significance.  In fact, it would be decades before it would be done conclusively.

This simple empirical observation, that stock prices appear to be unpredictable and random and that it is (almost) impossible to demonstrate any way in which they are not random, had far-reaching and profound implications.  The most important one with regard to our understanding of finance is that you can model the movement of stock prices as if they were random walks.  Just about all the useful stuff to come out of 20th Century financial theory was based on this trick, including our understanding of how to diversify portfolios and value options and other derivatives.

But as useful as EMH is as an assumption, it is lousy as a grand theory of how the stock market, or other financial markets, work.  Like the Flat Earth Theory, it collapses in on itself if you think about it too carefully.  Any explanation of how EMH could be true has to start with lots of clever stock traders that collectively find the perfect, all information reflected, true price. As new information arrives, those traders instantly move the price appropriately.  And how does that dynamic work?  How do those traders wind up with the right price? There must be an economic reward given to the smart traders for getting the price right and a penalty for getting it wrong.  In other words, it must be that some traders make money picking stocks, which violates EMH.

So even though they may appear to be random, for some traders some of the time, stock price movements are not actually random but are at least mildly predictable. To use a possibly strained sports analogy, the flurry of gestures the catcher makes tells the pitcher what to throw, but are presumably meaningless to the runner on second. To the runner, even though he knows the signals are meaningful to the pitcher, they can best be considered random noise.

Thoughtful people who understand the stock market don’t say that it can’t be beaten, they say it is very hard.  So hard, in fact, that it is unwise for all but a few to even try.  This got simplified by less thoughtful people as a belief that the market was perfectly efficient and that all market outperformance, even by Warren Buffet, was due to random chance.

The difference between stock price movements being actually random and might-as-well-be random may seem academic, but is not.  Firstly, the arguments made by advocates of stock picking against the Efficient Market Theory should impress no one.  Just because it makes no sense that beating the market is fundamentally impossible, it is not true that anybody can beat the market.

Secondly, while the evidence around EMH makes a good argument that an individual investor should not expect to successfully pick stocks, it does not follow that there do not exist professionals who can beat the market.  Arguing, as many do, that investing in an active fund is pointless because all fund managers are the equivalent of monkeys throwing darts is specious.  (On the other hand, the analogous argument that an individual investor is unlikely to be able to separate the monkeys from the geniuses, i.e. that picking mutual funds is no easier than picking stocks, has more than a little merit.)

And finally, it is worth observing that for many advocates of passive investing, their belief in the efficiency of markets is (appropriately) shallow and limited.  It is quite common, for example, and I think John Bogle subscribes to this, to believe in equity index funds but to advocate very large allocations to equity as an asset class, in some cases approaching 100%.  This is not consistent with a belief in efficient financial markets.

Allocating most of your money to stocks is itself an active decision that only makes sense if you believe that stocks as an asset class are cheaper than they should be.  If you thought the markets were perfect then you would assume that all asset classes, stocks, bonds, real estate, gold, etc., were priced such that on a risk-adjusted basis they all had the same expected future return.  Putting all or nearly all of your money in one class would then make no more sense than putting it all into a single stock.  You would get no improvement in risk-adjusted expected return, since that is impossible, but would greatly increase the risk you were taking on.

That’s not an unreasonable argument, and one that is perfectly consistent with Efficient Market Theory as I understand it. And yet I’ve never heard it anywhere.  Is it possible that this great and sinister theory isn’t quite as widespread as its detractors claim?

No Comments

  • By ObliviousInvestor, May 26, 2009 @ 9:02 am

    “On the other hand, the analogous argument that an individual investor is unlikely to be able to separate the monkeys from the geniuses, i.e. that picking mutual funds is no easier than picking stocks, has more than a little merit.”

  • By ObliviousInvestor, May 26, 2009 @ 9:04 am

    Whoops, misclicked and posted comment before I was finished.

    I was going to comment on the above quote saying that it sums up what I find to be the most valuable takeaway from EMH and related lines of thought.

    Also, the rule of thumb that Bogle generally provides regarding asset allocation is “have your age in bonds.”

  • By Greg, May 26, 2009 @ 9:06 am

    What is left out of the equation is where a particular vested interest lies. Trading stocks to make a profit at the end of the day is different than seeking return on investment over the next 20 years. A fund manager who is paid commissions on trades is different from one who is paid on performance.

  • By Dangerman, May 26, 2009 @ 9:36 am

    Interesting article Frank.

    Two points:

    “evidence around EMH makes a good argument that an individual investor should not expect to successfully pick stocks, it does not follow that there do not exist professionals who can beat the market.”

    Yes that’s true, but the -empirical data- shows that such professionals do not exist (over the long term). All the “great” prefessionals fail on the long term (see Peter Lynch, Bill Miller, tons of others).

    I think you’re unfairly glossing over some of the details of EMH. Of course people “beat the market” all the time, the question is whether -more- people do so than would be statistically expected by EMH? Every book I’ve read (Bernstein , Ferri, Swedroe, etc) says: no.

    “It is quite common, for example, and I think John Bogle subscribes to this, to believe in equity index funds but to advocate very large allocations to equity as an asset class, in some cases approaching 100%”

    No, Bogle does not advocate this. Page 208 of “The Little Book of Common Sense Investing” by Bogle states “my favorite rule of thumb is (roughly) to hold a bond position equal to your age.”

    In fact, I can’t think of a single major EMH author who does advocate this. Bernstein sure doesn’t.

  • By bex, May 26, 2009 @ 10:02 am

    I think its reasonable to say, unless you have information that others do not, your safest bet is an index fund.

    Personally, I prefer investing in privately held companies. Once a company is publicly traded, the concept of “having information that others do not have” becomes almost always illegal.

    So, folks who pick stocks successfully are usually riding the ragged edge of what is illegal. Either they move markets with their purchases, they “foment,” or they use barely legal bribes to get barely legal insider information a fraction of a second sooner than the rest of us… And then a lot of their gains are lost in the constant costs of transaction fees.

  • By Monevator, May 26, 2009 @ 10:15 am

    I think that asset allocation is a different issue to whether the market is efficient for stocks. To stretch the point for illustration, you might or might not be a private investor successfully picking stocks in the Russian market in 1910 despite efficient markets, but when the Bolshevieks seize the palace it’d be good to have some overseas assets/gold/whatever.

    Clearly by inspection the market isn’t always efficient (e.g. Dotcom bubble, Japan in late 80s) but utilizing such observations consistently and profitably without a time machine is another matter.

    Just found your blog btw, great stuff. :)

  • By Rob Bennett, May 26, 2009 @ 10:18 am

    “Thoughtful people who understand the stock market don’t say that it can’t be beaten, they say it is very hard. So hard, in fact, that it is unwise for all but a few to even try. ”

    I consider myself a reasonably thoughtful person, Frank. I say that the market can be beaten easily (by taking into consideration the price you are paying for stocks when setting your stock allocation). I say that every single investor alive should be trying to beat the market (that is, to take price into consideration). I have heard scores of people say that I am “mentally ill” to believe such things because of the pain that hearing that point of view causes them. And you suggest here that the Efficient Market Theory has not really done all that much harm?

    The Efficient Market Theory caused the economic crisis. That’s the reality (in my view, to be sure).

    You are right that there is just about no one who truly believes in this preposterous “theory.” Most people possess too much self-respect to try to put forward a serious case in defense of it. But millions invest as if the EMT were at least partly true. That’s problem enough.

    We all possess a Get Rich Quick impulse that tempts us into making investing decisions that are all but certain to destroy us in the long term. We all also possess common sense, which discourages us from giving in to the self-destructive urges. The EMT gives the devil voice within the pretense of scientific support. After all, if the market price is efficient, it must be kinda sorta on the mark, right? No need to lower one’s stock allocation just because prices are at three times fair value. It will all somehow work out.

    Yeah, right.

    My take is that the EMT is about 10,000 times more dangerous than you make it out to be. I agree with you that no one really believes in it. It doesn’t matter. We all want to believe. Giving people a “scientific” justification for believing what they want to believe but shouldn’t has proven (in my mind) to have been the most reckless move ever made in the history of personal finance.

    Mention of the Efficient Market Theory makes me go “grrrr….”

    Rob

  • By Dave C., May 26, 2009 @ 10:58 am

    Frank – this was a brilliantly written post. I’m currently juggling several books, but one is on Contrarian Investing by Dreman. He seems to talk a lot about the EMT (or EMH) crowd as an establishment of academics seeking to maintain a hold on investment practices. I assume it was these kinds of references you referred to in the beginning of your post?

  • By Kent @ The Financial Philosopher, May 26, 2009 @ 11:10 am

    Great post, Frank. You deserve large credit for explaining EMT/EMH intelligently and (almost) completely. Blog posts, by nature, can be quite a challenging media format for explaining such things.

    As with any idea, concept, hypothesis or theory, there is at least some degree of “truth” to EMH.

    Personally, I prefer the philosophical side of investing and finance because anything attached to nature (e.g. humans and their behavior) simply cannot be quantitatively explained, measured or predicted — at least not absolutely or with complete accuracy, which explains why “quant funds” usually implode when human behavior becomes increasingly extreme.

    The most successful investors tend to combine fundamental and technical analysis in their investment decisions. At some point, the quantitative analysis falls short and human judgment is necessary to make decisions.

    Of course, randomness (or luck) will normally explain some degree of an investor’s returns as well.

    The attempt to explain the nature of financial markets in a quantitative way is not unlike explaining emotion with numbers…

    “If the human brain were so simple that we could understand it, we would be so simple that we couldn’t.” ~ Emerson M. Pugh

    “The supreme paradox of all thought is the attempt to discover something that thought cannot think.” ~ Soren Kierkegaard

  • By Frank Curmudgeon, May 26, 2009 @ 11:58 am

    Oblivious Mike & Dangerman: I have apparently maligned Mr. Bogle a little. Sorry. But 70% in stocks for a 30 year-old would still be way too big if you thought that asset classes were priced efficiently, which I conclude he does not. Also, his old company, Vanguard, has a 2035 target fund invested 90% in stocks.

    Greg: Fund managers don’t generally get paid more if they trade more. Brokers do, which is a good argument against allowing your broker to manage your money.

    Dangerman: I haven’t done a lot of work in this area, but I believe that the data is consistent with both stories: that talented managers exist and that they don’t. The distribution of returns could be chance or it could be from a distribution of talent. There is no easy way to test this. I do believe, for what it is worth, that there is some serial correlation in mutual fund returns, that is, that a outfperforming fund in year 1 is slightly more likely to outperform in year 2.

    Rob: When I said “beat the market” I meant pick individual stocks to outperform the broader market. (Is there another sense of that term?) Do you not agree that this is very hard to do?

    Kent: You are certainly right about the limitations of blog posts as a medium. If only I had a book deal….

    And you are right about quant funds working best when the humans are acting typically, rather than totally crazy. We used to refer to this happy state of things as “normally irrational.”

  • By IndependentOperator, May 26, 2009 @ 2:09 pm

    @Frank, you are correct that both stories could explain the data, however, the reverse is not true. The data does not support both stories. This goes back to your null hypothesis discussion (which was mostly correct). The null hypothesis here is that the data is due to chance, and you must find evidence that is not the case, and that evidence must also be beyond the likelihood of random variations in the sample (some agreed-upon definition of statistical significance). The point is: the answer is “it’s just chance” unless you can find evidence otherwise.

    I do think the EMH stuff is taken too religiously, and the history behind the EMH is lost on most people, but at the same time, it is possible that you are interpreting some of the “silly academic thought” as exactly what I’m saying: chance is the explanation until you can find evidence otherwise. If you don’t hold that rigor, then your alternate hypotheses are just as random.

  • By Vince Anido, May 26, 2009 @ 2:59 pm

    I’m a little confused as to your conclusion. It seems clear that you are suggesting that EMT/EMH is bunk, but then I’m not entirely sure what you feel the ramifications of that conclusion are.

    If in fact EMT/EMH is false – then what? Everyone should invest in individual stocks? That people should continue to select actively managed funds?

    It seems to me that for the vast majority of investors, it makes no difference. Their best course of action is to stay with index funds and maintain a reasonable asset allocation.

    Thoughts?

    On an related note, the absurd allocations in the Vanguard (and all other) target date funds are mostly a result of competition between fund operators as they try to pump up their 5 year returns. Most planners suggest going with a target date fund 10-15 years earlier than you actually plan on retiring to get around this problem.

  • By ObliviousInvestor, May 26, 2009 @ 3:30 pm

    Vince, I think the intended takeaway is twofold:

    “Thoughtful people who understand the stock market don’t say that it can’t be beaten, they say it is very hard. So hard, in fact, that it is unwise for all but a few to even try.”

    …plus the snippet I quoted above.

    That reflects nicely where I stand on the issue anyway.

    Rob: Here’s my question for you. You say that “Every single investor alive should be trying to beat the market.” But even if we were all doing so, it wouldn’t improve our total return, would it?

    That is, there’s a finite amount of corporate earnings to be divided among shareholders. We can each try assorted tricks to get a bigger piece of them, but none of those tricks change the total amount of earnings. (Or rather, they tend to decrease the total as a result of expenses.)

  • By JJester, May 26, 2009 @ 5:27 pm

    Frank-

    I’m a college student at UCD, graduating this summer (thankfully). I’m a managerial economics major, and almost all of my finance professors swear by EMT, or, as we call it, EMH.
    Three professors told me to my face that I would over time, make no money at all in the stock market. They teach EMH as gospel over here, or at least most of them. So sometimes
    rants about the subject are apropriate. Personally, I agree that individual stock picks are extremely difficult to beat the market with, but I’ve consistently beat the market with
    picking a small portfolio every day, last year I got a 56% return and to date my return this year is 89%, I’ll probably break 100% sometime this week. Basically I just treat a stock
    as a puppet function of media exposure, make logical guesses, and it’s paid off. Isn’t that basically what logically follows given that EMH is false?

  • By Rob Bennett, May 26, 2009 @ 6:29 pm

    When I said “beat the market” I meant pick individual stocks to outperform the broader market. (Is there another sense of that term?) Do you not agree that this is very hard to do?

    Yes, I think effective stock picking is hard.

    Yes, there is another sense of the term “beat the market.”

    Passives often use the phrase “you can’t beat the market” to suggest that investors shouldn’t increase or lower their stock allocations in response to big price swings. The Efficient Market Theory is used not only to argue against stock picking. It is also used to argue against timing the market. I believe that timing the market (not short-term timing, but long-term timing) is essential for those hoping for long-term success.

    Bill Bernstein uses the term “micro efficiency” to refer to the type of efficiency that argues that you can’t pick stocks effectively and macro efficiency to refer to the type of efficiency that says that you cannot time the market effectively. I don’t believe that the market is efficient in either sense. But I don’t believe that the micro efficiency claims have done too much harm whereas I believe that the macro efficiency claims have done a great deal of harm.

    At least your choice for a Tuesday blog entry got my blood going again after a three-day weekend! I like the title a lot.

    Rob

  • By Rob Bennett, May 26, 2009 @ 6:46 pm

    Here’s my question for you. You say that “Every single investor alive should be trying to beat the market.” But even if we were all doing so, it wouldn’t improve our total return, would it?

    That’s a fantastic question, Mike.

    My answer is going to be mysterious one — “Yes and no.”

    If we all engaged in long-term timing (increasing our allocations when prices got too high, lowering them when prices got too low), the amount of the total profits to be distributed would be roughly the same. In that sense the answer to your question is “no.”

    However, there is a another sense in which the answer is an enthusiastic “yes!”.

    If we all practiced long-term timing, prices would be greatly stabilized. We would not see runaway bulls and we would not see runaway bears.

    That means that we would not have people believing that they held far more in assets than they did in reality and these people would not be spending money they didn’t have on cars and houses and vacations. Everyone would be far better able to plan his or her financial future in a world in which stock valuations did not go to extreme highs or lows.

    Because we would plan our financial futures better, we would not see economic crises of the type we are living though today. The primary cause of the economic crisis is that middle-class investors have come to realize that most of their bull market gains were cotton candy and that their retirement hopes have been imperiled — they have cut back on spending as a result and that puts the entire economy on hold. If prices had never gone to the moon, spending would never have been so insane and the return to reality would not have caused any problems (we would have always remained in reality).

    If the economy hadn’t gone under, we would not have had to spend billions in stimulus packages. That would have meant we would have incurred less debt. That would have meant we would be seeing less inflation in years to come. The problems that would be solved by Rational Investing (paying attention to price when setting one’s stock allocation) go on and on.

    We now have millions of investors who retired thinking that they had saved enough and who are going to experience busted retirements because they took seriously the numbers that appeared on their portfolio statements during the insane-price years. That’s another negative.

    We have caused a lot of income inequality. Millions of middle-class investors have been ruined. As you note, the size of the total pie has not been changed. That means that the small number of wealthy investors who understand the need to take valuations into consideration (or who were able to afford to pay for high-price investing advisors who tell the real story) have made out like bandits.

    Another thing is that a lot of middle-class investors are going to swear off stocks as a result of what has happened to them (and as a result of what is likely going to happen in coming years). I view that as a negative too. I would like to see most middle-class investors become long-term investors.

    And we have experienced a lot of unnecessary anxiety as a result of the unnecessary pumping up of prices and then the unnecessary deflating of prices that inevitably follows from the unnecessary pumping up of prices.

    I view the stock market as a common resource, like the environment. I believe that we all have a responsibility to do what we can to protect it and to take care of it so that it will be there for future generations. I do not believe that we are doing a good job of this today.

    Rob

  • By ObliviousInvestor, May 26, 2009 @ 7:20 pm

    Yeah, after I asked the question, I came to suspect that your reply would be something to that effect.

    Makes sense to me.

  • By Dangerman, May 27, 2009 @ 7:00 am

    @Frank: “I do believe, for what it is worth, that there is some serial correlation in mutual fund returns, that is, that a outfperforming fund in year 1 is slightly more likely to outperform in year 2.”

    Actually, “A Random Walk Down Wall Street” answered this exact question with a resounding: no. As this article states, “A study done by Burton Malkiel in his book “A Random Walk Down Wall Street” compares the performance of the 20 best funds in the 1970s to their performance in the 1980s. All but the Magellan Fund, which was run by Peter Lynch, could not keep up their above-average results. In fact, the top 20 funds not only underperformed the market as time went on, but they also underperformed the average mutual fund. (We should note that Malkiel wasn’t just data mining; the study has shown the same results over many time periods).”

    http://www.investopedia.com/printable.asp?a=/articles/mutualfund/03/070203.asp

    This study is on page 167 of the new paperback version.

    I’m still waiting for empirical evidence that EMH is wrong.

    Also, one point I think has been unfairly glossed over in this discussion is: the EMH isn’t really all or nothing. Bogle, and others, often say that brokers, active managers, and all the other Wall Street types are necessary -in order- to make the market efficient. But, once the market is reasonably efficient, all -further- “active” activity produces zero marginal benefits.

    @Rob, the strategy of market timing based on fundamental valuations is a very common one. Although I have no idea about the exact number, I would guess that there are at least hundreds of mutual funds that use some variation on this basic strategy. Do you have any data showing that these funds outperform over the long term?

    The wonderful thing about the EMH is that even if a “new” strategy can reliably produce above-average performance, so much money flows into those assets that the prices are driven up to where the strategy no longer works. Many authors describe the efficient market as “self-correcting.”

  • By Frank Curmudgeon, May 27, 2009 @ 8:09 am

    IO: Not to get too obscure, but failing to disprove EMH is not the same as proving it. I’m very uncomfortable with it as an explanation of how the stock market works so am not willing to accept it as the simple answer I must buy in the abscence of evidence to the contrary.

    Vince Andio: I have a more cynical explanation of why the equity weights in target (and other allocation funds) are so high.

    Rob: It seems to me that advocating a fixed allocation such as 70% to equity based on a belief in efficient markets is inherently bogus, since it implies a higher expected (risk-adjusted) return to equity. Why don’t you say this more often?

  • By maxwellthedog, May 27, 2009 @ 9:15 am

    Frank, your final theory is actually a form of the Black-Litterman asset allocation model, or a Bayesian asset allocation model, where the market caps of different asset classes serve to indicate what the allocations of different asset classes within a portfolio should be. I think there are some issues with this idea (namely restictions around the issuance of different types of assets, ability to invest in those assets, cross border legal restrictions, etc) but it does create a powerful framework for creating a more broadly diversified portfolio than a typical MVO model would.

    As for the acceptance of EMH, I would have to agree with JJester– MBA and finance classes are often taught by professors who cling to a near-religious view of EMH. Which can be amusing when their class is full of students who plan to go out an violate that view to earn a living. I have been working in the guts of the markets for more than 10 years now, and know as deeply as anything that EMH is routinely violated.

    That said, even practitioners who disagree with EMH often hold beliefs that are rooted in EMH– like using the random walk theory of prices to value options. It works great– until it does not, and then even the pros are wiped out. I think the implications of EMH are deeply rooted in many parts of the financial system (largely because it lends itself to cleaner, easily computable models). This is to the detriment of the financial system overall, in my opinion.

    Finally, from what I have seen about people who advocate a 100% allocation to equities, I think it is partly due to the fact that they do not understand risk-adjusted returns. Siegel has everyone convinced that in the long run, higher returns from stocks are guaranteed. But this ignores the path-dependence we all face along the way. It also ignores the profound implications of the price at which you buy.

    I am with you on this one. As far as I know, we only get one “toss of the coin” in this life. If that is the case, then the argument for considering risk-adjusted returns (and diversification) is a hell of a lot stronger than people realize.

  • By Frank Curmudgeon, May 27, 2009 @ 10:44 am

    Maxwell: Now just a sec, it is not my theory that stock allocation should be the cap weight of equities in the larger investment universe. I’m only saying that is the rational conclusion from a belief in efficient markets. Since just about nobody advises this, I conclude that when push comes to shove the belief in EMH is not as widespread and certainly not as deep as often supposed.

    It saddens me to hear that most finance professors really believe EMH, or to be more precise, EMT. I guess I have been very fortunate to have studied with wiser ones.

    That said, I don’t think that basing financial theories such as options pricing on EMH is a bad thing. All that is necessary is to believe that EMH is a very accurate and useful approximation of how stock prices move. The fact that at the edges EMH doesn’t make sense doesn’t itself undermine CAPM or Black-Scholes, any more than the fact that Newtonian mechanics doesn’t work under certain circumstances undermines civil engineering.

  • By Rob Bennett, May 27, 2009 @ 11:33 am

    Rob, the strategy of market timing based on fundamental valuations is a very common one. Although I have no idea about the exact number, I would guess that there are at least hundreds of mutual funds that use some variation on this basic strategy. Do you have any data showing that these funds outperform over the long term?

    Knowing that wouldn’t tell you anything unless the fund being studied were engaging only in long-term timing. If the fund was also doing something else (my guess is that all of the funds you are thinking of also do something else), there is no way to know whether a negative result comes from the something else or not.

    This is the big flaw with all studies indicating that mutual fund managers are not able to pick stocks effectively enough to beat an index fund. Why would anyone think that there is a mutual fund manager who is aiming only to obtain the best results for his fund and not also to market the fund? My guess is that most are pursuing some combination of those two goals. Marketing considerations require fund managers who want to succeed to make bad stock picks (stocks that are positioned for long-term success are rarely the most popular stocks and the most popular stocks are rarely positioned for long-term success). I do not find any of the studies that look to mutual-fund performance against index fund performance to argue that the market is efficient to be even a little bit persuasive.

    We do have 139 years of stock-return data. That data shows that long-term timing always works. I find that (combined with the fact that it is impossible for me to imagine any way in which long-term timing might not work — for it not to work, valuations would have to have zero effect on long-term returns) persuasive.

    There has never been a study showing that long-term timing does not work. All of the studies that look at the question show that it does. Shiller is the leading researcher in this area. But John Walter Russell (owner of the http://www.Early-Retirement-Planning-Insights.com site) has done wonderful work that focuses on more specific questions and that examine more strategies for implementing the “valuations matter” insight in a multitude of ways.

    Rob

  • By Rob Bennett, May 27, 2009 @ 12:20 pm

    It seems to me that advocating a fixed allocation such as 70% to equity based on a belief in efficient markets is inherently bogus, since it implies a higher expected (risk-adjusted) return to equity. Why don’t you say this more often?

    You are the first person in history ever to ask that I make one of my anti-Passive Investing claims more often, Frank. Are you sure that’s what you really intended to say?

    I’m just joking around.

    My personal belief is that all arguments in support of Passive Investing are rooted in emotion. They are all rationalizations, in my assessment. The Efficient Market Theory argument is indeed one that I have seen put forward on numerous occasions. It’s a weak argument, in my assessment. But I don’t personally view it as being particularly weak. My take is that, when we talk about Passive Investing (the idea that it is not necessary to change one’s stock allocation in response to big price changes), we are in the realm of emotion and faith-based belief systems and dogmatism, not logic. (I mean no personal insult to any one who holds these beliefs — there are many smart and good people who believe strongly in the Passive Investing concept.)

    Rob

  • By Rob Bennett, May 27, 2009 @ 12:27 pm

    I think the implications of EMH are deeply rooted in many parts of the financial system (largely because it lends itself to cleaner, easily computable models).

    Absolutely. The EMH concept is an outgrowth of the Rational Man or Economic Man economic model. That’s classical economics, Adam Smith’s invisible hand concept. All of these ideas are related (and all are just true enough to cause a lot of trouble, in my assessment).

    The common theme is that they all assume rationality among humans, a group not known for acting in a solely rational manner in its real-world endeavors. If we were 100 percent rational, all this goofy stuff would indeed follow.

    Rob

  • By Rob Bennett, May 27, 2009 @ 12:33 pm

    All that is necessary is to believe that EMH is a very accurate and useful approximation of how stock prices move.

    It’s not my intent to be argumentative. But I feel a need to say just for the record that I do not at all agree with this statement (at least not in the way that I am hearing it), Frank. I believe that it is primarily emotion that determines stock-price movements in the short term.

    However, I can see how it might be that rational factors determine relative pricing (that is, both Apple and Microsoft might at some point be at three times fair value but the difference in the pricing between the two might be roughly right all the same because of EMH-type factors).

    Rob

  • By Mr. ToughMoneyLove, May 27, 2009 @ 12:43 pm

    To me EM Theory is a label and theory adopted by academics to explain why most stock “experts” are no better than dart-throwing monkeys, which I believe is true, particularly if you ignore short run success. Look to what has happened, as just two prominent examples, to the recent performance of Buffet and the former geniuses at Fidelity Magellan. If stock picking was an actual skill or science to be acquired and used on a consistent basis by experts, we would probably not know about those experts until their death. Why? Because if they were truly confident in their abilities to beat the market, they would not shoot themselves in the foot by sharing their picks with others. Sharing of that expertise can cause market trading that distorts the “expert” analysis. Those that sell stock picking expertise want others to take the risk that the darts are being sent in the wrong direction.

    So I don’t care what theory is used to keep my money out of the hands of dart-throwing monkeys.

    As for your finance professors, this generally applies: Those who can, do. Those who can’t, teach.

  • By mark, May 27, 2009 @ 5:46 pm

    If EMT is not correct, why aren’t all (or even some) of the experts able to beat the market all of the time? Why don’t the majority of actively managed mutual funds beat the market?

    If pension-fund managers and experts on Wall Street can’t beat the market consistently, what hope does the little guy have?

  • By IndependentOperator, May 27, 2009 @ 6:48 pm

    “Not to get too obscure, but failing to disprove EMH is not the same as proving it”

    That isn’t the point. The point is that EMH is the most appropriate explanation until you find a more appropriate alternative. The error you are making is saying the EMH has problems, therefore your other explanation is better. It’s not, because you haven’t shown it to be.

    That isn’t to say EMH doesn’t have problems and isn’t wrong. These are two different things. EMH can be clearly wrong and still the best explanation we have. There are numerous examples of this scenario in the sciences.

  • By Dangerman, May 27, 2009 @ 8:58 pm

    @Rob “it is impossible for me to imagine any way in which long-term timing might not work”

    Here’s one clear and easily understood answer: “the stock multiple is not a mean-reverting series. On the contrary, the height of today’s P/E ratio relative to the past tells us nothing except that (1) interest rates are far below average and (2) future earnings are very likely to rise from today’s depressed base.”

    http://www.forbes.com/2009/05/11/price-earnings-ratio-interest-rates-stock-opinions-contributors-shiller.html

    “We do have 139 years of stock-return data. That data shows that long-term timing always works.” … but… “Why would anyone think that there is a mutual fund manager who is aiming only to obtain the best results for his fund and not also to market the fund? … I do not find any of the studies that look to mutual-fund performance against index fund performance to argue that the market is efficient to be even a little bit persuasive.”

    Things that always work in back-testing, but have never actually worked in real life, rarely get my money.

  • By Frank Curmudgeon, May 27, 2009 @ 10:51 pm

    Mark: My view is that at most one portfolio manager in five is actually talented, and the ratio is worse in mutual funds since the pay and conditions are better in hedge funds and I-banks, provided you have actual talent. (And I say this as an unemployed manager. Draw your own conclusions.) By definition, the average manager can’t outperform since the average manager gets the market average return.

    IO: You will be unsurprised to hear that I see no flaws in my view of how markets operate nor inconsistencies with available data. I do see a huge problem with using EMH as an actual theory (i.e. as EMT) because it can’t explain how stock prices are discovered without paying the traders/investors who are good at finding the right prices.

    My view is that there exist a relatively small number of market participants who are actually talented, have a better than random tendency to beat the market, over time amass more capital to work with, and profit from driving the process of price discovery. Surely that’s not so implausible?

  • By IndependentOperator, May 28, 2009 @ 12:25 pm

    @Frank,

    You brought up the explanation of null hypotheses. Criticizing others for not understanding that EMH is a null hypothesis is kind of silly if you yourself can’t demonstrate an understanding of it. You can reject EMH anecdotally if you want, but if you are trying to suggest that your view of the markets is somehow more sound than EMH without any evidence whatsoever, you won’t be surprised when no one pays attention. And that’s a shame, because you have a very valid point. But your science is wrong and your conclusion that EMH must be rejected without any alternative explanation is wrong.

  • By Frank Curmudgeon, May 29, 2009 @ 12:37 pm

    IO: This is where I wonder if I am as good a writer as I usually think. Because this is exactly my point. EMH was not concieved as an attempt to model the real world, but as a rhetorical device. The failure to disprove it as expected is a profound thing, but is still not a proof that it is true, nor that anybody ever thought of it as being possibly true. Affixing the null hypothesis label to efficient markets was as much an accident of history as anything else. Assuming that we agree that the evidence is consistent with both EMT and not EMT, why should we allow EMT to win by default?

  • By IndependentOperator, June 1, 2009 @ 11:47 pm

    @Frank, assignment of EMH as the null hypothesis is not random, that’s why. If two students get all questions of a quiz correct, the default answer is not that they are superhuman cyborgs created by the cow-god Moogon in an effort to balance the energy in the universe after Tom Cruise disrupted it when he starred in Mission Impossible 3.

    No, the simplest explanation is that they guessed.

    Does that mean this answer is correct and the former answer is not? No. But to suggest that you first start with the former answer and only accept the latter answer when you find supporting evidence is missing the point of null hypotheses altogether.

    That was the point I was trying to make. Perhaps I am the poor writer.

  • By TrueBlue2, May 24, 2011 @ 1:25 pm

    Excellent, excellent series of comments. A special thinks to Frank and Rob. I thought you might want to hear of another interesting application for EMH put forth by one of the beloved Phd Quants. The argument is that the market for corporate credit facilities or “revolvers” is also efficient. If Bank A will lend money at x% so will ten or twenty or 100 other banks. So, NOT true.

  • By Larry Lix, December 20, 2011 @ 3:36 pm

    I was told long ago, and thought it was junk, “for somebody to gain money, somebody has to lose it”. I asked “What about inflation”, “What about growth?” etc…etc… all the things that the financial people had filled me up with their garbage and sales hype.

    It’s true. The money has to come from somewhere and after years of investing and reading a few things have become painfully evident.

    - stock values are not based on anything real and have no bearing on the company profits.
    - any financial gain you extract comes from somebody else’s pockets. Hopefully it is no yours.
    - The only sure winners is the sales people that run this phoney scam. Most of these people have failed at many other ventures in their vocational life.
    - Money doesn’t come from nowhere. See my first sentence.
    - If you attempt to net more than 8% you will lose.

  • By Paul Williams, May 25, 2012 @ 6:43 pm

    I’m surprised you didn’t discuss the various forms of EMH (weak, semi-strong, and strong). I’m also surprised no one else has mentioned them.

    I agree with the conclusions you’ve come to about EMH and it’s proper uses. But it seems you’re only focusing on the strong form and maybe the semi-strong form. In my opinion, the weak form is the only one that seems to hold any water as a hypothesis. However, this paper/book by Lo & MacKinlay purports to discredit the entire hypothesis: http://press.princeton.edu/books/lo/ (Link takes you to a page with links to read the full text in PDF. Unfortunately, you can’t download the entire thing as one PDF file.) Chapter 9 looks interesting as it pertains to finding a model for predictability.

  • By Frank Curmudgeon, May 30, 2012 @ 5:46 pm

    I don’t think the different flavors of EMH really change the basic story. In order for any of them to work somebody has to be systematically making a living keeping the market efficient, which itself violates EMH.

    I have an actual hardcover version of Lo & MacKinlay that I spent $45 on when it came out in 1999. (Come to think of it, I probably spent $45 of my company’s money on it.) Chapter 2 is the work I reffered to above when I said that it took decades to finally beat EMH.

  • By Paul Williams, May 30, 2012 @ 6:39 pm

    Ah, well when I have more time I’ll have to actually read the whole thing.

    I see what you’re saying about the different flavors of EMH. I guess I’ve always held a very weak view of it, so I haven’t pushed it too far. Even if it is a poor “theory,” the fact that it has taken so long to disprove is interesting.

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