"Are Markets Efficient?" asked the MD

A question that frequently came up a few years ago in my interviews was "Are markets efficient?" I'd usually answer, "Yes," weak form (data), semi-strong form (news) and most of the time "strong form". My classes/textbooks always said the market was efficient, even strong form (insider info).

What is the right answer to this question, especially in an interview. If I took a stance on markets being efficient at a buyside shop they would always follow up with "Then why do we exist!"

Now I think I'd answer the question this way. Tech traders are a joke. News based hedge funds sometimes can make it happen. If you walk the line and dig up legal inside info and you can profit. Somewhere in the middle falls the buyside mutual fund guys. They follow fundamental analysis where their projections differ from the market (Warren Buffet). In my job I see my companies make very profitable acquisitions independent of their synergies.

Conclusion: Public equity markets generally efficient, but there are some real deals in small cap PE and good old fashion fundamental analysis.

 

Someone correct me if I am wrong, but academically efficient markets is the party line, but industry wise you should say markets are inefficient or something along those lines.

Reality, they are probably semi strong efficient. Most of the markets are efficient most of the time.

 
AnthonyD1982:
Someone correct me if I am wrong, but academically efficient markets is the party line, but industry wise you should say markets are inefficient or something along those lines.

Reality, they are probably semi strong efficient. Most of the markets are efficient most of the time.

Yep. 2008 is a stellar sign of market inefficency.

 
CharlesWManuel:
AnthonyD1982:
Someone correct me if I am wrong, but academically efficient markets is the party line, but industry wise you should say markets are inefficient or something along those lines.

Reality, they are probably semi strong efficient. Most of the markets are efficient most of the time.

Yep. 2008 is a stellar sign of market inefficency.

I can't tell if this is sarcasm or not. Regardless, a lot of people are using specific examples to refute market efficiency. I don't think markets are perfectly efficient, but I wouldn't use anomalies as a proof against EMH or anything else for that matter. You get inefficient markets when you start looking at emerging countries, complex derivatives, stocks without a lot of coverage, etc. Anything with information asymmetry will cause inefficiencies.

Academics are the building blocks for present day finance, but when you take a theory into the real world it doesn't always hold. If you are asked an academic question in an interview the goal is to take what you learn in school and intelligently discuss it in the realm of the practitioner.

 

Markets are extremely inefficient. Read some books by Buffett/Graham/Klarman and you will see that Beta and the EMT are an absolute joke.

Explain how Bear Stearns falls from $60/share to $2/share in two days...

Explain why the Dow fell 22% in a single day back in 1987. .....

Explain why Enron crashed in 2001

If the market was efficient, it would not have such wild gyrations. The most notable to me was the crash in the price of oil in 2008 from $145 to $29 !!!

"Mr. Market" is very irrational

 

practioneers will tell you they would be out of their job, if markets weren't inefficient

At the micromarket level (the person to person level that makes markets generally efficient in long-term and broadly), practioneers will tell you they would be out of their job, if markets weren't inefficient.

Someone has to take advantage of arbitrage (at the micro level), and it is their actions that make overall markets efficient and especially over the long term.

Though without risk, arbitrage,exist in inefficient markets such as PE, HF, small cap, emerging and institution high capital investment.

 

Markets are inefficient.

-------------------------------------------------------- "I do not think there is any other quality so essential to success of any kind as the quality of perseverance. It overcom
 

This point is very much still being debated. Efficiency is measured by the model which prices the market. To say the market is efficient/inefficient you first need to assume that your model is correct. New research are underway and the trend is that the current models are insufficient in pricing the market. Risks like liquidity, momentum (it could be a risk factor), price/dividend yield, SMB, HML can explain a lot of the gyration in the market. As you can see I'm in the rational/efficient camp.

Market participants say markets are inefficient. What they don't realize is that they are taking on risks. When you make a bid/ask you are taking on liquidity risk. When hedge fund trade on what they thought was alpha (riskless profit), they discover that they are also trading on liquidity risk (see the quant fund meltdown during the crisis). And don't forget what Stiglitz said, and I paraphrase: markets aren't inherently efficient, but market participants actually drive prices up and down to make it so. So what fundamental research really is is that it is your reward for making that effort.

 

How would this be for an answer at a buy-side interview? "Markets are relatively efficient, because people like us are out there searching for asset prices that are inefficient." I truly do believe that, I'm not just trying to come up with a good answer. Markets are fairly efficient, that's why it's not easy to make money in the market. On the other hand though, there is plenty of room to find over/underpriced assets through hard work. The fact that so many professionals jobs are to find mispriced assets, is the reason markets are pretty (but not completely) efficient.

 

Markets are not efficient. It reminds me of a story at a hedge fund where they ask their interns if they think markets are efficient. If they say yes - "well you shouldn't care if I fire you right now. You should be able to find an equivalent job immediately."

I don't know how to say it nicely but this is a pretty clear acid test for who is still in school. There is a fundamental difference between "goods"markets and "asset" markets - "goods" markets are much closer to efficient (but not fully) than "asset" markets and it's a huge mistake to conflate the two.

The cute little stories about the baker making X loaves of bread and the price goes up because of demand simply do not apply when you're dealing with modern financial markets.

For a market-making interview, I believe the classic gutsy response is, "Only when I'm making them efficient."

My view is that markets are relatively efficient, but they pay for services- services like making securities the right price, as well as liquidity. SOMEBODY has to make money by making sure these stocks reflect their intrinsic value and help get investors in and out of positions- why not you?

 

In theory, Yes. In reality, Maybe Not and we cannot get prosperous to using the fact that it isn’t. Even an insider trading could not get benefit from the market. When the insider buy a share, other investor may follow their action. The stock may rise and the investor could not get higher return. But hell, who cares. As long as we have a job, it doesn’t matter. For interviews, I’d answer yes or no according to the firm.

 
TheBuySideGirl:
In theory, Yes. In reality, Maybe Not and we cannot get prosperous to using the fact that it isn’t. Even an insider trading could not get benefit from the market. When the insider buy a share, other investor may follow their action. The stock may rise and the investor could not get higher return. But hell, who cares. As long as we have a job, it doesn’t matter. For interviews, I’d answer yes or no according to the firm.

When the "insider buy a share, other investor may follow their action." - Yes this is what you WANT to happen. If you buy a share, you want others to buy it AFTER you so the price goes up. So you can then sell it. You know, buy low, sell high?

What firm would you say "yes there are efficient markets"??

ideating:
When the "insider buy a share, other investor may follow their action." - Yes this is what you WANT to happen. If you buy a share, you want others to buy it AFTER you so the price goes up. So you can then sell it. You know, buy low, sell high? What firm would you say "yes there are efficient markets"??

Maybe I meant a bit further. The investor(insider) won't get higher returns as he'd expected in the first place as the price goes up while he builds up his position. And I could say yes at any interviews and get away with it as long as I make things clear and logical enough.

 

In an interview setting, the interviewer is not looking for the correct answer; they are looking at the way you think about the problem. The key is to able to speak intelligently about the subject. Make your point, support it with evidence, and they will be impressed. You have to realize that even the academics have trouble substantiating or refuting EMH... how much can an interviewer really know?

 
swetom:
adapt or die:
Since the financial meltdown Thaler and the behavioralists have been getting alot of traction. Human beings have shown they do not act rationally all the time.

I probably would not go Gene Fama on a buy side interviewer.

His name is actually Eugene Fama.

you may or may not be aware of this but Gene is a common nickname for Eugene

Eugene Francis "Gene" Fama (born February 14, 1939) is an American economist

hope this helps

 
NYNY:
As long as there is information asymmetry, there cannot be perfectly efficient markets. And believe me, information is never symmetric.

Is this true? I think the logic of EMH is not that there's symmetric information, but rather that those who know what a stock should be priced at will bring the price back to "the correct price" whenever it's off.

 

In regards to whether or not behavioral finance/economics is right, that's not really the academic question. The question is, can they come up with testable hypotheses. The issue many economists and finance professors have with the behavioral crowd, is not that they claim everyone is not rational (economists already know this, and have forever), it's that the behavioral people have a hard time modeling their thoughts, and giving us theories and hypotheses that help us make sense of the world.

Another area that gets too much attention is whether or not economists should be able to predict the crisis. The fact is, one of the best models we have for understanding business cycles says that no one can predict booms and busts.

 

The only interviews at which you should say markets are efficient are if you're interviewing at an index-tracking place or some shit like that.

As for the correct answer to the question, no, markets are not efficient, and such a statement is as specious as Econ 101. Essentially, the argument goes that financial markets are somehow the ONLY markets in the world that are completely efficient in real life and not just in textbooks, without a shred of evidence. There's no evidence that firms operate in efficient markets, or else why would they be able to make profits; there's no evidence of efficient job markets, as the above post demonstrates(1); and there's no evidence of efficient financial markets, as the entirety of human experience will attest to.

(1) Would disagree with the premise that, in an efficient market, he shouldn't care about being fired; being fired would send a signal to an efficient market that his value is less than currently appraised. However, the central point is spot-on.

 

the only correct answer to this interview question (assuming you want the job) is "markets are inefficient, and it is up to us to exploit those inefficiencies."

seriously, if you start to say some shit you learned in class about the proof of the efficient market hypothesis, you might as well stand up and walk out of his office right then and there.

 
Monument Man:
the only correct answer to this interview question (assuming you want the job) is "markets are inefficient, and it is up to us to exploit those inefficiencies."

If enough people are trying to exploit these efficiencies, then don't markets become pretty (but not completely) efficient?

Monument Man:
seriously, if you start to say some shit you learned in class about the proof of the efficient market hypothesis, you might as well stand up and walk out of his office right then and there.

I'm honestly not trying to be a wiseass, but I don't think there is a proof of the EMH. Otherwise it shouldn't be called a hypothesis right? (If there's a proof for it, it should maybe be called the EM Theorem?)

 

No way are markets effiicient. Think about the idea of prices at equilibrium or price=value. To every investor, the value you'd receieve from owning that particular share is far too subjective than what it's priced at. The volume of markets will only exacerbate that thought further.

An example: Would you expect a corvette convertable to be priced the same in Ancorage,AK and Santa Monica, CA?

Different people buy/price/sell secutities for different reasons (capital preservation, mid-return, high-return, risk trade-off, liquidity, beacuase the ticker is the same as his initials). Prices are determined by what someone is willing to buy at, but also if you are trying to sell, nobody has to actually sell for less. You hold and hope you're right.

 

Totally unrelated, but the previous post reminded me of a funny story.

I owned a bar on an island in the West Pacific for a while. This was an island with only about 400 Americans, so we all knew each other. This one particularly ugly American (looked down on the locals, acted like an ass, etc...) went so far as to buy a brand new Corvette and have it imported to the island. This was a bad idea on many levels, not the least of which was the highly corrosive sea air of a tropical island. Anyone who spent more than $2,000 on a car (affectionately known as "Guam bombs") got taken. But I digress.

He drove his new Vette to work the first week he got it, and all his employees (predominantly Philippine nationals and a handful of locals) came out to "admire" the car. You would've thought someone died and made him Pope. What a jerkoff. Anyway, after a while one of his employees asked him why he parked the car in the parking lot. Wasn't he afraid of what the tropical sun would do to that paint job?

So he asks this guy where he should park, and the local tells him that the coconut trees throw off the best shade and will protect the paint on his car. He immediately moves it under the largest coconut tree and goes back to work. He comes out at the end of the day and finds at least a half dozen huge coconuts have fallen out of the tree during the day and put big dents in his new Vette. All the locals are laughing hysterically.

Two lessons here: first and foremost, don't be a douche. Second, local knowledge is vitally important. Don't piss off the locals.

 

Just wanted to answer a point from earlier on.

"Markets are volotile. The DOW Rockets +/- 50% annually. How can markets be efficient"

Efficient markets do not suggest volatility will not exist. Efficient markets have large swing because probability of future cash flows change. When the financial system is in collapse and the future is uncertain than a efficient market prices this new information into the market. The recent crash was evidence of semi-strong form efficiency. Strong form could be questionable since no one was properly assessing risk.

 
BCbanker:
Just wanted to answer a point from earlier on.

"Markets are volotile. The DOW Rockets +/- 50% annually. How can markets be efficient"

Efficient markets do not suggest volatility will not exist. Efficient markets have large swing because probability of future cash flows change. When the financial system is in collapse and the future is uncertain than a efficient market prices this new information into the market. The recent crash was evidence of semi-strong form efficiency. Strong form could be questionable since no one was properly assessing risk.

Not only that, there is research being done showing that people's risk appetite changes over time. In good times, they require less return for a given risk, therefore pricing can continue to go up even though the prospect of return hasn't changed. Same goes for bad markets: when shit hits the fan, people require more return on the same assets, and prices fall even lower to justify the increased risk aversion in addition to the expected drop in cash flows.

In other words, huge volatility is not inconsistent with EMH. It all depends on the model which you price assets.

I read a lot of the comments above, and I realize that a lot of people have no idea what market efficiency is. It postulates that the price of the asset reflects all available information (in terms of strong form, semi-strong form, and weak form). In essence, it means you can't systematically make risk-less returns, i.e. alpha or arbitrage. If there are risk-less returns, they should disappear quickly. People can have different opinions on how things are priced, but what they are really doing is taking on risks that they might not be aware of, and the returns will reflect those risks. Please note from portfolio theory, that one does not get compensated for idiosyncratic risks, so buying one very risky stock does not necessitate a very high average return. Also note, there are limits to arbitrage (transaction cost, in many forms) that can give raise to seemingly risk-less profits. But once those are taken into account (priced them in), you realize you can't trade on them.

 

On the subject of "Are people rational or irrational?":

Were people rational or irrational back when they pray to rain gods for rain? Or when they thought the Earth was flat and at the center of the universe? No! That's the facts as they know it, and they acted upon those facts very rationally. As they learn more about science and physics, they changed their behavior to reflect those new realities.

This is the same for pricing assets. Everyone is acting to their best of their ability to maximize their utility (higher returns and lower volatility, among other things). Do they know exactly what everything is worth? Nope. But we try. And as new information or model comes out that prices things better and better, we change our perspective and our respective outlook on a certain asset. In hindsight sometimes it looks like people are irrational. But we can look back with perfect clarity and they can't. A good example is the housing bubble. Were people acting irrational thinking they can buy houses with only modest incomes? No, housing has not had a negative year in the last 80 years, and we haven't had unemployment like this for the last 30 years. Also people were greedy, and their risk appetite increased and they are much more willing to lever up and take more risk.

The essence of EMH is not that everything is price correctly - that requires an uber-model that is 100% correct that can tell us what that benchmark is, which is not possible in the foreseeable future, but it is that the current price is the consensus of market participants given their sets of realities.

ideating:
It's real simple; you want the job, you say markets are inefficient. You want to circlejerk with a bunch of college kids and people who don't watch markets, you rationalize about the different interpretations of how the market is efficient.

Bingo!

 
AnthonyD1982:
ideating:
It's real simple; you want the job, you say markets are inefficient. You want to circlejerk with a bunch of college kids and people who don't watch markets, you rationalize about the different interpretations of how the market is efficient.

Bingo!

This mentality is why we got into trouble this past two years. People thinking their trades are sure bets, without thinking that maybe there is risk involved that they're not seeing. I traded for a living before going to business school, and I'll be trading after. Just because you "watch the market" doesn't mean you're right. It about approaching the markets with the correct mindset and an intellectual curiosity to learn more.

John Meriwether blew up three hedge funds thinking the markets are inefficient. The markets doesn't care what he thinks, and proved him wrong.

 

Market efficiency theory is a great intellectual fraud like Nassim Taleb states in the "Black Swan." I think academics use this theory to justify their themselves for not being successful in the financial markets. You can ask yourself how some have made extremely high abnormal returns to guide your opinion on the efficiency of markets. Making it in the markets is not an academic thing, it's a philosophical thing(it takes uncommon wisdom).

 

I was under the impression that the efficiency hypothesis was written with regards to an entire populations behavior and asserts that all investors actions due to new information will be normally distributed. The examples of a couple, or even hundreds of people making returns that far exceed the market actually is not evidence for inefficiency as the model itself allows for these variations. The point is that when you examine all investors, we all do in fact follow the market. Also, when you examine the big players (i.e warren buff), the reason they are so successful was small successes that compounded into a large enough cash resources that essentially increase their chances to big in the part of the normal distribution that lies above the market performance. So yea, markets as a whole are pretty efficient because the gains of a minority don't destroy the model of efficiency. As others have mentioned though, there can be different definitions of efficiency.

 

jnl83:

"Efficient Markets" is a broad street lingo (could be used broadly to refer to related topics. Most people probably refer to the EMH when they think "Efficient Markets".

The EMH does not directly discuss and has nothing directly to do with "risk" (although risk is important). It only merely relates "prices" with "information", and that is it.

The EMH or the efficient-market hypothesis is an academic theory - asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all available information, and instantly change to reflect new information. Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already has, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

 

Hi rmivalue, please read these two interviews of Richard Thaler and Gene Fama by the New Yorker:

Thaler: http://www.newyorker.com/online/blogs/johncassidy/chicago-interviews/ Fama: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-wit…

I quote Thaler: "...there are two components to the theory. One, the market price is always right. Two, there is no free lunch: you can’t beat the market without taking on more risk. The no-free-lunch component is still sturdy, and it was in no way shaken by recent events: in fact, it may have been strengthened. Some people thought that they could make a lot of money without taking more risk, and actually they couldn’t. So either you can’t beat the market, or beating the market is very difficult—everybody agrees with that."

I think hearing it from the two side by the two experts in their respective areas would tremendously benefit this thread. The New Yorker also interviews other University of Chicago economics/finance professors. They are interesting to read.

 
jnl83:
Hi rmivalue, please read these two interviews of Richard Thaler and Gene Fama by the New Yorker:

Thaler: http://www.newyorker.com/online/blogs/johncassidy/chicago-interviews/ Fama: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-wit…

I quote Thaler: "...there are two components to the theory. One, the market price is always right. Two, there is no free lunch: you can’t beat the market without taking on more risk. The no-free-lunch component is still sturdy, and it was in no way shaken by recent events: in fact, it may have been strengthened. Some people thought that they could make a lot of money without taking more risk, and actually they couldn’t. So either you can’t beat the market, or beating the market is very difficult—everybody agrees with that."

I think hearing it from the two side by the two experts in their respective areas would tremendously benefit this thread. The New Yorker also interviews other University of Chicago economics/finance professors. They are interesting to read.

nice post

 

I don't see how the EMH holds up to the flame-test of market bubbles. I would be more inclined to side with behavioral economics/finance in that often times it appears that irrational exuberance (and the polar opposite) can take hold... particularly when the participants think they won't be the last ones with their hands caught in the cookie jar.

Jack: They’re all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard. -30 Rock
 

Seriously though, EMH is overly reductionist. According to EMH, it's fundamentally impossible to consistently generate alpha over time, which is clearly not true if you take one look at some of the world's most successful investors.

I think its pretty hard to fully support EMH when you look at periods like the first tech bubble. Why would the stock of a company that records consistent loses hand over fist still post triple digit returns for investors? Because human's are irrational, emotional lemmings that want to make a quick profit. The price eventually had nothing to do with intrinsic value and more to do with infectious enthusiasm.

The nasdaq saw a price increase of something like 300 percent (off the top of my head) between 1998 and 2000, compared to maybe 20-25% in the DOW. We focus our attention toward companies that make us hopeful, as we ignore sturdy, profitable companies with long track records of success. Hence the comment about coke and tp.

Value investing has become pretty wide-spread, so I guess it is becoming harder to find value over the long term, in theory. But if you read the news, there is no shortage of profitable companies that do something to put a blemish on their reputation and thus, their price.

I guess people who make their living as traders would be more inclined to support EMH than strictly value guys.

"Strength does not come from physical capacity. It comes from an indomitable will."
 

"For example, on Black Monday did the long term prospects of the companies that crashed really deteriorate by 20%+ in a single day? When the tech bubble escalated, were people being rational when they abandoned all tenets of valuation and started buying companies on hype, price-to-click ratios, and the like? My vote is a solid no, that these are excesses caused by fear and greed, and the more patient & liquid you are, the more you can profit off of this."

EMH doesn't state that crashes can't happen, they can and do happen but the market has mechanisms of correcting itself.

After black monday we didn't see a sustained death spiral or an overshoot, eventualy prices recovered and we moved on.

 

I think you have basically answered your own thread perfectly: as long as there are human emotions involved in investing, the EMH does not hold and will never hold.

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing. See my Blog & AMA
 

I think it's close to true over really long time periods (though not completely), but that different strategies (growth, value, momentum, etc) work better in different time periods/ general market conditions. People see what's working and, as that gets to be more public, the comparative advantage of the strategy disappears and something else will be preferable.

I do think that a lot of people on this website are too quick to dismiss EMH and what it brings to the table. Yes, it's pretty reductionist, but so are all models. It doesn't give you the 100% true story, but it does give some context as to the (extreme) difficulty of generating alpha. It also at least forces people to think about the diversified investment approach (diversification benefits should not be taken lightly even for sophisticated investors).

 

It's impossible to prove whether the EMH is right or wrong - it could be that you're using the wrong model to describe variation in returns or it could be that markets are inefficient. Even the academics and hardcore indexers will admit that limitation.

But the idea of efficient markets is still a powerful tool. It's a fact that when you add up all the investment holdings out there, the average investor must hold the market portfolio. Therefore, after you account for fees & expenses the average active manager has to underperform the market. What's even more powerful - something like 97% of all mutual funds fail to generate alpha beyond a random sampling distribution if you test it against a 4 factor model. In other words, even if you had zoo monkeys running all the mutual companies, some of them would inevitably beat the market and look like 5th percentile performers, 1st percentile performers, etc. just out of luck.

That's the biggest thing I think people miss about EMH: it's not a question of seeing CAPM alpha on one stock or one fund's prospectus, you really need to think about how everyone out there is doing and whether you could replicate that performance for cheap. If you're thinking about investing in a mutual fund (or hedge fund for that matter), ask yourself whether you really believe they're in that top 3%, or maybe they're just loading up on other risk factors that you could get exposure to through an ETF. Or if you're making a direct stock pitch, ask yourself what it is that you've uncovered that the analysts at Fidelity, Janus, etc. are missing. If you can answer those questions, you're doing pretty well in my book.

 
Downtown:

It's impossible to prove whether the EMH is right or wrong - it could be that you're using the wrong model to describe variation in returns or it could be that markets are inefficient. Even the academics and hardcore indexers will admit that limitation.

But the idea of efficient markets is still a powerful tool. It's a fact that when you add up all the investment holdings out there, the average investor must hold the market portfolio. Therefore, after you account for fees & expenses the average active manager has to underperform the market. What's even more powerful - something like 97% of all mutual funds fail to generate alpha beyond a random sampling distribution if you test it against a 4 factor model. In other words, even if you had zoo monkeys running all the mutual companies, some of them would inevitably beat the market and look like 5th percentile performers, 1st percentile performers, etc. just out of luck.

That's the biggest thing I think people miss about EMH: it's not a question of seeing CAPM alpha on one stock or one fund's prospectus, you really need to think about how everyone out there is doing and whether you could replicate that performance for cheap. If you're thinking about investing in a mutual fund (or hedge fund for that matter), ask yourself whether you really believe they're in that top 3%, or maybe they're just loading up on other risk factors that you could get exposure to through an ETF. Or if you're making a direct stock pitch, ask yourself what it is that you've uncovered that the analysts at Fidelity, Janus, etc. are missing. If you can answer those questions, you're doing pretty well in my book.

Yeah, I would add on to this that you'll gain a lot more from a portfolio perspective (just through added diversification) by investing in active managers that invest in strange/illiquid things that you couldn't otherwise get on an index. I would never invest with some guy who routinely takes bets like AAPL vs. MSFT (not to say that I myself would never make that play, but you just can't know if someone else is actually better than everyone else..there's just not enough data per manager).

 

Using mutual funds or etf's to support EMH is a tautological argument regardless of whether they index or not. It simply doesn't take into account the other possibilities for generating returns. For the average investor (I mean someone with reasonable knowledge and expectations), the reason to buy mutual funds is precisely to create a theoretical beta of

"Strength does not come from physical capacity. It comes from an indomitable will."
 

I am a physical economist. In economic planning there is a quantitative aspect that suggests that in contemporary "Big Data" environment eventually markets will be able to "run" themselves without any emotions. Rational people rely less on emotion and make logical decisions based upon facts and circumstances. I suppose that if a person buys in to a "fad" then they posses a greater risk factor. That risk factor is greater than that of person who observes that the US markets and stocks in general move consistently upward for well mananged stocks. That being said, I am an efficient marketeer under an exclusive rule: that all participants know the risks and are "adult" enough to invest without emotion---they do their homework.

 
Countess Capital LLP:

I That being said, I am an efficient marketeer under an exclusive rule: that all participants know the risks and are "adult" enough to invest without emotion---they do their homework.

Finally my first WSO post, have been on the boards for months!

Having conducted a research paper on the subject I would like to give my 2 cents on the subject:

I totally agree on the fact that the majority of market participants do their homework and investing without emotion.

However, I would like to debate the fact the incentive systems of the PMs encourage herd behavior strongly and a great proportion of the PMs will follow suit if a PM with exceptional track record and fine reputation makes a move in the marketplace. The risk of acting in a non-conformist manner is just so large that many of the PMs will not take it as it is way safer to go with the crowd and have approximately market returns compared with the two possible scenarios of beating the market or underperforming the market.

Another, totally out of context example would be if you went out with your HS football teammates, everyone ordered a beer at the bar and you would be ordering last making an order for a 20 oz milk.

A few interesting articles on the subject:

Choi, N., Sias, R.W. 2009. Institutional industry herding. Journal of Financial Economics. Vol. 94, No. 3, pp. 469-491

Stone, D.F., Miller, S.J. 2012.Leading, learning and herding. Mathematical Social Sciences. Vol. 65, No. 3, pp. 222-231.

Chater, N., Frith, C., Raafat, R.M. 2009. Herding in humans. Trends in Cognitive Sciences. Vol. 13, No. 10, pp. 420-428.

 

I completely agree that EMH is bullshit. Was one of the few students in my investments class that got pissed when professor tried supporting and teaching us this idea. She then went on to state that nobody can outperform the market over the long run because markets are efficient, pitching us a bunch of BS and I wanted to call her out but used self-control because care too much about my GPA.

twitter: @StoicTrader1 instagram: @StoicTrader1
 

I've been reading these forums for a few months, but this is my first post here, yay!

In my experience, mostly those people who don't know much about EMH think it's complete BS. I'm not saying that I would have studied it extensively (I haven't) nor that it holds in every single situation. EMH basically states that the market reacts to information efficiently, and that arbitrageours correct the irrational behavior of some marketeers. EMH can never be proven true, but the fact that it hasn't been proven false makes me think that it could be a good model for market behavior. From what I've seen, markets do seem to overreact to big news, but the market also also seems to correct the prices quickly. Besides, it seems that no one can consistently outperform the market. If the markets were not efficient, at least to a significant degree, wouldn't there be many more people out there who outperform the markets almost all the time?

 

Shiller has done some interesting work in this space. "From Efficient Markets Theory to Behavioral Finance"

http://www.jstor.org/discover/10.2307/3216841?uid=2&uid=4&sid=211041406…

Read the section on excess volatility. He finds data supporting Samuelson's comment that markets are "macro inefficient, micro efficient".

Is there any actual empirical evidence that supports EMH?

 

I just recently heard Eugene Fama's Nobel Prize lecture. What he says is that all of his work in asset pricing is based on the "2 siamese twins of asset pricing". That is to be able to check if the market does what it is supposed to do, one needs to define what it is supposed to do in the first place. To me this is a really good statement.

I really believe that the arguments of efficient markets are very very strong (Arbitrage, Random trades by uninformed traders cancel out each other, efficient information procession, and so on...). But I don't believe that as of today we have a model that expresses both a) peoples utility functions and b) peoples measurements of the factors involved in their utility. A prominent example for a) is preference for skewness in expected return distributions. It can be shown in real live examples that people renounce average returns for skewness in the distribution, controlling for risk. Most prominent example is people playing the lottery. Other examples are people investing in mining expeditions (often lower sharpe ratio but high anticipated return distribution skewness). An example for b) would be value investing in my eyes. People use value metrics as a common risk factor besides the market beta because it adds value (i.e. is a future predictor instead of a lagged indicator). But value gets more complex if you add fundamental firm profitability to the equation. A lot of work is currently done at that end.

 

By the way, skewness has not been shown significant in an empiric test so far, mainly because it is hard to measure. (at least from what I know).

Also I just thought of an example that is harder to explain: Low beta assets have been shown to provide stronger Sharpe Ratios than high beta assets. This effect is classically explained with restrictions that investors have on leverage and it can even be shown that the magnitude of the effect gets higher when the TED spread widens. However, if the theory of efficient arbitrage holds, then this explanation must be wrong.

How do you guys think about institutional explanations for anomalies in general?

 

I personally invest on the belief that in the large / mega caps, I do not have the required knowledge or expertise to outperform. I work on the assumption that big companies are generally pretty well priced and I will only invest in them if there is clearly a huge overreaction (Black Monday, 2008, BP oil spill etc.). I hold 70-80% in a global equity ETF and the remaining 30-20% in micro cap equities (sub 100m) where I do believe you can find value by doing the required due diligence.

this. my bread-and-butter is large/mega caps, and it is extremely hard to generate absolute outperformance, with most of our outperformance coming from downside protection (our holdings go down less than peers', and try to keep pace during rallies), rather than tremendous gains.

when you do micro caps, the difficulty is not only the lack of research available, but liquidity. for individuals, this is no problem, but you might imagine if an inst'l trader puts out an order that ends up being 50% of the daily volume, the ability to outperform is going to be sucked up by HFTs and arbitrageurs.

 

At the end of the day, EMH is a manifestation of what the 'thinking' class has longed for, mathematical perfection resembling the Form postulated by Plato. Stock prices just exist in the aggregate minds of those who play the game. There is no way to perceive the "Form" price, the true price of stocks; knowing this, we can only approach it by incorporating available information and allowing this information to flow into largely flawed valuation methodologies. There are at least three major presuppositions in the previous sentence: 1) People process information with rationale faculties; 2) The information is processed into aggregate numerical forecasts that prognosticate with consistent enough accuracy to make it statistically reliable; 3) The market, which largely uses flawed and assumption dependent valuation methodologies, may not be at all close to this "form" price, but because everyone uses these methodologies, the prices persist in the ticker.

The stock market just seems like a giant game of poker to me. Know what the other players are doing and make decisions based on what they are thinking.

 

Costs to short-selling (e.g inability to borrow at the risk-free rate) can lead to what we observe as the low-beta anomaly. It has been known for some time that the the capital market line is flatter when risk-free rate borrowing is restricted (Black 1972).

Progress has been made in recent years on explaining the momentum, value, and size anomalies (the latter of which is almost immaterial). Adrian and Etula (2013) find that aggregate broker-dealer leverage effectively explains the returns associated with these strategies, and the cross-sectional returns of treasury bond portfolios sorted by maturity. A broker-dealer leverage factor performs as well as the Carhart four-factor model + Cochrane's bond-pricing factor in explaining time-series returns. See Pederson's "Margin-based Asset Pricing and Deviations from the Law of One Price" for a good overview of the literature on the subject.

I think Fama has done himself a disservice by continuing to use term "efficient market". What does efficiency even mean? That information is "quickly" incorporated into price? How quickly? How can this be falsified? Moreover, what's "the market"? The market portfolio that includes all assets? Even if we define "efficiency", it may not be particularly informative to speak of the efficiency of the "market". The market for U.S. equities is probably more "efficient" than the market for my labor, the market for my cell phone, or the market for housing.

 

about your low beta comment, my curiosity is on why people have persisted to invest according to MPT or even by using volatility as the sole determinant of investment success, not on the merits of the research. somewhat selfishly, I hope this effect persists because by happenstance I tend to invest in lower beta stocks :)

I agree on the terminology part, although I think he would've attracted a lot more criticism if he used "rational."

 

Anyone that thinks that markets are literally efficient is an idiot. The relevant question for us is whether markets are inefficient enough to allow one outperform after transaction costs.

"My dear, descended from the apes! Let us hope it is not true, but if it is, let us pray that it will not become generally known."
 
Illuminate:

Anyone that thinks that markets are literally efficient is an idiot. The relevant question for us is whether markets are inefficient enough to allow one outperform after transaction costs.

@Illuminate hit the nail on the head. The question isn't whether markets are efficient or inefficient. It's how efficient or inefficient are they?

EMH is just a theory under a number of assumptions. One of which is that people will always react rationally (which we know isn't always the case).

 

I'm definitely in the "it's a good framework, but is incomplete" camp. I think the data shows that there have only been two managers in history whose performance cannot be explained by random chance: Buffett and Peter Lynch. I think Bill MIller would also have been in that category up until the crisis, when he massively underperformed. If markets were just flat inefficient, you would expect there to be many more managers with statistically significant outperformance over long time horizons. I think the data is overwhelming that markets are pretty efficient over longer time horizons (e.g. most Fama French style analyses use annual data). But there are huge intra-year swings which depend on behavioral biases and overreaction. That's where active managers need to keep level heads and generate their excess returns.

Also agree with above poster that EMH does not preclude financial crises or market crashes. Fama would simply argue that risk premia increase when there is more uncertainty about the future of markets (e.g. Sept 2008), and these higher risk premia can lead to significant (and justified) corrections in prices. When clarity returns, risk premia come down and prices go back up. None of this suggests markets are acting inefficiently.

 

I think an expert is a very specific area can make superior returns within that one specific area if they make a limited amount of trades. For example, I spend 3-4 hours every day reading about politics/world affairs...My rate of return on trades based on these type of events (e.g. russia, debt ceiling) is extremely high. If I invested in SP500 ETF, and then a few times a year took some money out to make bets on foriegn and domestic policy events, I'd have a positive alpha.

The issue is, almost everyone starts to think they are a genius after they get superior rate of returns, so they starts investing in things that aren't experts in. So I start making earnings plays on Apple, and losing a lot of money. Or, if you're running a fund, you get more and more money in the fund, until you're forced to make bets in things you aren't an expert in, to try to maintain your rate of return.

 

I don't think the existence of a small handful of top investors disproves EMH. If you have 100 million active or semi-active investors in the world then you will have a small handful who outperform their peers, even over decades. The odds are in favor of the existence of a few top performers, even out of pure luck. Plus, I'd wager that the best performers are actually great at lobbying government, actively manage the companies they invest in, make investments large enough to move markets, have developed a reputation that causes markets to move on their words or opinions, etc.

The correct answer is that markets are largely efficient, particularly with the advent of high-end computer technology in the 1980s. But efficient markets simply reflect available public information. There will always be a place to make excess returns by investing against the market, physically visiting facilities, being a first mover (there will always be first movers, even in efficient markets), or by exploiting your superior understanding of an industry that the general public lacks.

 

it definitely gets tons of public criticism, but if you look closely at fund managers, many of them are closet indexers (see my post above about active share). many managers will say they don't believe in EMH but their actions speak louder than words, when you correlate heavily with the S&P and are doing worse net of fees, you're a closet indexer. in order to say you truly disagree with the notion that markets are efficient/rational, you have to walk the talk.

next time you see somebody talking openly about EMH, take a peek at their 13F or their fund's website for their active share stats, you may be surprised

 

The crux of the issue is that EMH is a theory meaning that it has never actually been proven, but statistics support that the market works this way. In general though as one of the base rules of economics, people respond to incentives. If there is an incentive to buying a tech stock with a severely inflated valuation people will buy it.

You would think that with more computerized trading that the market would move closer to a strong example of EMH, but at the end of the day like OP said human intervention prevents a truly efficient market.

 

EMH can have useful implications from a portfolio management perspective, but taking it too seriously in its most orthodox form that everything is priced in has serious logical flaws:

  1. They assume everything is instantly priced in due to a large number of market participants, thus negating any benefit to active security selection
  2. That large number market participants are in fact active managers (if they were passive then they wouldn't care about incorporating in market information)
  3. If the market is efficient, then it is because of active management, not despite it. You can't have it both ways.

That being said, I do believe that passive indexing can play a role if for no other reason than to keep active mutual fund managers honest, but if you take EMH to its most extreme, it doesn't make sense. Josh Brown had a good article on this a while back called "The Passive Investing Taliban."

If you're comparing a market index against ALL mutual fund managers (or SMA managers, whatever), you're committing all kinds of logical fallacies, the first one being is that you're assuming that all fund managers are rational actors. That's a bad assumption. Many are run by complete fuck-ups who raised assets through their personal network and maintained those relationships, so you are lumping in managers with skill with every idiot out there. No wonder why the aggregate data looks bad compared to the index.

 
JulianRobertson:

EMH can have useful implications from a portfolio management perspective, but taking it too seriously in its most orthodox form that everything is priced in has serious logical flaws:

1. They assume everything is instantly priced in due to a large number of market participants, thus negating any benefit to active security selection
2. That large number market participants are in fact active managers (if they were passive then they wouldn't care about incorporating in market information)
3. If the market is efficient, then it is because of active management, not despite it. You can't have it both ways.

That being said, I do believe that passive indexing can play a role if for no other reason than to keep active mutual fund managers honest, but if you take EMH to its most extreme, it doesn't make sense. Josh Brown had a good article on this a while back called "The Passive Investing Taliban."

If you're comparing a market index against ALL mutual fund managers (or SMA managers, whatever), you're committing all kinds of logical fallacies, the first one being is that you're assuming that all fund managers are rational actors. That's a bad assumption. Many are run by complete fuck-ups who raised assets through their personal network and maintained those relationships, so you are lumping in managers with skill with every idiot out there. No wonder why the aggregate data looks bad compared to the index.

 

Let's be clear that economic "rationality" does not have the same meaning same as the colloquial use of the term "rational". Depending on the source, economic rationality may only mean consistent preferences (which is not as crazy an assumption as it may sound). The definition may be expanded to included utility maximizing. An interesting note: some of the more restrictive assumptions of the CAPM can be relaxed without substantial changes in outcomes (see Lintner 1969). For example, Black (1972) derives a model without a risk-free asset in which the CAPM still holds (though unlimited short-selling is "allowed").

Regardless, if we define "EMH" as the hypothesis that stock returns can be accurately modeled as a martingale, then I think that the evidence shows pretty conclusively that it is false. But no one ever thought that was literally true. Fama makes this clear at least once in his original "Efficient Capital Markets" (1970):

"First, however, we should note that what we have called the efficient markets model in the discussions of earlier sections the hypothesis that security prices at any point in time 'fully reflect' all available information. Though we shall argue that this model stands up rather well to the data, it is obviously an extreme null hypothesis. And, like any other extreme null hypothesis, we do not expect it to be literally true..."

All models, "are to be used, not believed." They are all approximations.

 

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