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What are everyone's thoughts on the efficient market hypothesis?

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Pete Caya

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I recently learned about the Efficient Market Hypothesis in my Micro-economics course. When I first heard about it from my professor, i was kind of shocked that such an idea exists. Anyway, I did some research, and now it makes even less sense! According to EMH, the market right now reflects all predictable current and future trends for the different investment possibilities, so it is impossible to predict what stocks will do well.

My problems is that there are deviations, and not just the statistical kind. If there was a plumber or someone that made a fortune like Warren Buffet, I would believe because that would mean that it really is just random. But all of these people are extremely well educated.

What do more knowledgeable people here think though.

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Markets are efficient... but... (humongous "but")... the "strict" forms of the EMT are more misleading than helpful. The strict forms appear to remove human beings from the equation and treat the market as if it is a machine. It is not. Efficiency is achieved via a process. In fact, efficiency is achieved when human beings recognize inefficiency and bet their money on their evaluations, and when the rational bets win out, which can take a while.

Added (30 minutes later): It is only fair to say that the very weak forms of the EMT make sense in some contexts: for instance, from the context of a typical layperson who wants to invest money. I've had friends who will say something like this: GE is a good company, so I'll buy some GE stock and keep it for many years. Now, some weak form of EMT would be the right response. Something like: don't you think people realize this and have already bid the price of the stock up? If GE's competitor, Company X is not so good, wouldn't the experts who are trading the two stocks make sure that the prices reflect this? Buying a top-quality item is not necessarily a no-brainer, if it is priced highest too.

So, to a layperson, one might begin with that weak (and actually true) formulation of "markets tend to efficiency", and it is quite good advice to suggest that people diversify very broadly if they want to go it alone.

Edited by softwareNerd
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The core of the idea makes perfect sense, although it does have some rather bizarre interpretations and often have dubious assumptions thrown in to make the detail.

The essential core is straight forward: a very large number of people are constantly and eagerly seeking out information about businesses, and use that information to make their investments. That investment process then incorporates the information into the prices of those investments, and so prices move to the 'proper' levels accordingly very fast. Those who figure out the right investments to make first make money, while those with less information or who learn it later do not make money.

It only gets stupid when people introduce those ludicrous assumptions and draw conclusions accordingly. They say that markets should act instantly to new information becoming available, so the path of prices is called a "random walk", following deviations that nobody predicts in advance. However, if this were true then nobody would make money (ie over the ordinary cost of capital for a given risk level) other than by luck or wrong-doing. Without those two, nobody could make money, but that would then eliminate the movitation for people to do research and price investments accordingly. With that, just as SNerd points out the strong-version of the EMH breaks down because nobody is acting to bring the efficency about, leaving behind just vicious accusations.

What really happens is that people in markets do not act instantaneously but are very quick. There must be at least some small possibility of making money through research and investment - derided as the continued existence of some 'inefficiency' - to continue to motivate people to research and act accordingly. There can never be "100% efficiency", but it can get close to it. In this fashion it could be said that a form of the Peter Principle is at work: people rise to the level of their incompetence. In the finance world, that means people make money up to the point that their speed and quality of interpretation of information allows them to. And with that, true effort and ability, and the fruits thereof, are recognised. Since people *are* highly educated, as you note, this then makes market efficiency very high indeed. What explains Buffet, therefore, is his superior ability to interpret information and not be swayed by emotion.

JJM

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I recently learned about the Efficient Market Hypothesis in my Micro-economics course. When I first heard about it from my professor, i was kind of shocked that such an idea exists. Anyway, I did some research, and now it makes even less sense! According to EMH, the market right now reflects all predictable current and future trends for the different investment possibilities, so it is impossible to predict what stocks will do well.

My problems is that there are deviations, and not just the statistical kind. If there was a plumber or someone that made a fortune like Warren Buffet, I would believe because that would mean that it really is just random. But all of these people are extremely well educated.

What do more knowledgeable people here think though.

The problem with the academic version of the EMH is what they think an efficient market means. They want the market to be efficient without any real reason.

But since nothing happens instantaneously, there is not going to be a situation where all information is reflected in a stock's price at any given moment. There is a lag, however long or short, before information affects stock prices...and new information is constantly coming to the market.

I would say that efficiency would show the best possible information that is available at any given time perhaps, but not all information.

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But since nothing happens instantaneously, there is not going to be a situation where all information is reflected in a stock's price at any given moment. There is a lag, however long or short, before information affects stock prices...and new information is constantly coming to the market.

All prices are efficient in that given the market research of the seller, that is the price he thinks he can get with an acceptable buyer. If he has information regarding some future possible event -- i.e higher demand and therefore higher prices for gasoline and therefore shipping -- he may either lower or raise his prices to encourage more sales while still staying in the profitable margin.

Some people seem to think that whatever a market is doing -- i.e. the stock market -- has already taken everything into account, and to fully accept that idea, one would have to believe that all parties to the transaction have all the information and will act on it rationally. However, not only isn't this always the case, but also rational people can have different understandings of the available facts, even if they all had the exact same data and it was all of the data available. For example, do you think the "bail-out" plan with all of its manipulations of the markets bode well for the long-term future or not? There seems to be a lot of hesitancy in an answer to this question, which is one reason markets all over the world are so volatile. They all know the "bail-outs" will go into effect, but differ on what that means to the various economies.

So, even with up-to-the-second data efficiency, there are still going to be differences in how to act -- i.e. to buy or to sell at a given price -- and this difference is what makes it possible to either lose a fortune or to make a fortune in the stock market. I haven't figured it out, because to me, the nationalizing bailouts are going to cause big problems down the road, and yet markets go up when various government nosy into markets with force and arm wrenching manipulations.

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Some people seem to think that whatever a market is doing -- i.e. the stock market -- has already taken everything into account, and to fully accept that idea, one would have to believe that all parties to the transaction have all the information and will act on it rationally. However, not only isn't this always the case, but also rational people can have different understandings of the available facts, even if they all had the exact same data and it was all of the data available. For example, do you think the "bail-out" plan with all of its manipulations of the markets bode well for the long-term future or not? There seems to be a lot of hesitancy in an answer to this question, which is one reason markets all over the world are so volatile. They all know the "bail-outs" will go into effect, but differ on what that means to the various economies.

That too...good point :D

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I recently learned about the Efficient Market Hypothesis in my Micro-economics course. When I first heard about it from my professor, i was kind of shocked that such an idea exists. Anyway, I did some research, and now it makes even less sense! According to EMH, the market right now reflects all predictable current and future trends for the different investment possibilities, so it is impossible to predict what stocks will do well.

My problems is that there are deviations, and not just the statistical kind. If there was a plumber or someone that made a fortune like Warren Buffet, I would believe because that would mean that it really is just random. But all of these people are extremely well educated.

What do more knowledgeable people here think though.

It isn't remotely true but it makes the math a lot easier.

I believe Buffet said something to the effect of "If the Efficient Market Hypothesis were true I'd be living on skid row".

If markets were efficient your investments would have substantially lower returns.

The fact is none of EMH CAPM MPT and the rest of the standard basket of economic theory is correct and that is part of the reason we are having all these financial problems right now.

All the risk models were all wrong so no one was hedged against the event the has happened.

Edited by punk
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It's important to consider that the efficiency of the market is continually improved by aggregation of wealth. Successful businessmen and investors aggregate wealth while less successful ones lose wealth. This tends to concentrate economic power in the hands of those most capable of understanding and anticipating the market. This leads to efficient allocation of resources, including investment money. To the vast number of investors not in the position to attain and understand information about the market advantageously, it's a useful simplification to assume an efficient market, and to match your strategy to this model by diversifying and counting on overall increasing efficiencies, productivity and aggregate wealth to gain a profit.

This works to a point, but it can lead to problems when principles that hold true generally, lead to uncharted territories where they fail. Those investors who catch on most quickly to the new situation maintain more wealth/power than those who do not, and continue to add to the efficiency of the market.

It's also important to note that efficiency can break down where short term profitability diverges from long term efficiency, such as in a bubble environment, when short term profit potential overrides a sober evaluation of fundamental value.

The real problems arise when irrational power/money enters the market and obliterates predictability. Under normal circumstances, this irrationality/unpredictability can last only until the new money changes hands from the irrational to the rational. This might not happen until the irrationality runs its course and the market collapses, but it will eventually happen.

If there is a continuous transfer of money from the rational to the irrational, such as by forced expropriation by an altruistic government, the efficient market hypothesis loses its grounding. Rational investors are forced to anticipate, not only the market, but the irrational actions of the government.

The government, unwilling to admit to its own irrationality, uses its coercive power to blame the market for the failures, a rationale to expropriate more wealth from the rational to use to its own irrational means. This mechanism leads to increasing irrationality in the market until eventually the market fails and all trading is dictated by the government.

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