EMH is eating my brain
If stock prices are random in nature or follow a Brownian path what are market participants doing in the market? It'll be very disrespectful to say that all of them are fools and don't know what they are doing on a daily basis.
I believe market prices don't follow a Brownian path always, as there are constant bull attacks which drive the stock price up and vice versa.
Ps. There are many people who've beaten the market average consistently over a long period.What do you guys think about it?
Insider trading beats the market every time.
Simply do not believe in EMH
EMH is like believing in Santa, but for finance nerds
It's not about "believing", it's like how physics problems assume no friction. Obviously friction exists, but "no friction"is a useful assumption to study physics. Similarly, EMH and no-arbitrage are useful assumptions to study economics. Clearly markets aren't perfectly efficient IRL, but it usually helps to start out with a simplified theoretical model and then modify it to be more accurate to the real world.
Practically, you can assume no-arbitrage / EMH for certain assets like ETFs (you will never ever successfully execute ETF arbitrage when you're competing with HFT / market makers) and short-term ATM options on liquid stocks/indices. But EMH is less reasonable for other assets like small-cap stocks, real-estate à la 2008, cryptocurrency, etc.
Nerd.
The simple model is that Santa brings you presents, then you modify that to the real world where your parents actually gave you the gifts.
Agree with the assumption part. EMH is a great theory to humble people. It's like an intellectual rollercoaster: 1. I'll become rich through markets --> 2. It's impossible based on EMH --> 3. Notice inefficiencies in the EMH and focuses on those 'opportunities' that contradict the theory. The main issue with EMH is when people stop at point 2 and take that as the final truth without ever reaching point 3. This is also a general rule of thumb for life: To break/exploit the rules, first, you must master them.
Finance PhD is for you
To preface I'm just a college student, so take what I say with a grain of salt.
My understanding is that even if strong EMH were true(1), it requires many market participants to actually make asset prices efficient. Prices don't just naturally reflect the value of assets - they find equilibrium through market participants buying/selling and arbitraging away opportunities.
(1) I personally think EMH is closer towards semi-strong if anything. It leaves room for outperformance (from say Buffet, Robertson, etc), and there are many instances of prices not accurately reflecting value over a reasonable time frame.
Exactly, In extreme circumstances, prices are either too cheap or too expensive.
Markets are reasonably efficient via wisdom of crowds. However, EMH only works if information is fully disseminated among the public with enough market participants acting upon that information and with no systemic biases. Given that humans have limited rationality with various heuristics that produce common biases, markets are not always efficient.
I don’t think you necessarily have a clear understanding of what Brownian motion is. The idea is that the stock price represents its expected value in the future (also referred to as a martingale) and that changes beyond that are unpredictable but follow some sort of probability distribution that is how we derived the current value. Brownian motion is the basis for Black-Scholes and a lot of quant work.
Correct me if I'm wrong, but I thought a martingale was something that had no drift (i.e., an asset that ONLY moved based on its random walk)
You're right but that doesn't contradict what he said. If there's no drift then the best guess for the future stock price is the current price. Note even if there is a drift you can still view it as a martingale from a risk neutral perspective.
It's been a while since I've been at university and I'm not a quant so apologies to my quant friends if I get this wrong.
It's no that stock prices are random and follow a Brownian motion, it's that the CHANGE in stock prices are random. So people use a Geometric Brownian Motion with drift where drift equals the expected return or the risk-free rate under risk-neutral pricing to model stock price changes.
But it's important to note that this is just a model. We're limited by the statistical methods available to us. Just because we believe a GBM is the best tool to model stock price changes, it doesn't mean a stock price follows a GBM.
Common misunderstanding. You don't have to believe in random Brownian motion to believe in the EMH. Stocks could follow a non-random perfectly predictable pattern and the EMH could still be true. The EMH doesn't say stocks aren't predictable, it just says *you* can't predict any better than the aggregate market consensus.
IE, imagine a perfectly predictable stock that everyone agrees with 100% certainty will increase by the risk-free interest rate over the next year. There is no arbitrage there, the price always goes up the exact same amount, no way for you to "beat the market", so that price is efficient, even though it's non-random.
Yes, but the EMHers believe that the price accurately reflects all the information in the world (as if all of the market participants are rational beings, with no biases and all of them act same on the available information), so it's not possible for anyone to call the shots. And if anyone (many people have done it) ever beats the market, it's was because of pure luck and no expertise at all. Price is always right and Buffet is a statistical outlier and all his theories are fraud. There is no way one can generate alpha. Fama even goes as as far as to explain the black Monday was due to information available (and the next day all that information became irrelevant).
I think you're slightly exaggerating here. EMH basically says: 1) future prices should not be predictable from past prices, and 2) prices factor in publicly available information.
In order for EMH to work, someone has to actually be setting the prices. This where informed investors like hedge funds come in.
EMH can never be completely true for all participants in the market, because clearly, if it doesn't pay to generate alpha, then no one would generate alpha, and no one would be around to set efficient prices in the first place! It's more of an approximation that's used to further the study of economics and finance.
Think about CAPM. Everyone uses CAPM. CAPM makes no sense without EMH. It's not like everyone who uses CAPM believes that markets are perfectly rational; it's just an assumption that underlies that particular model. Same thing with DCF or LBO or Black-Scholes - all these fundamental models only make sense if you're trying to act as a rational participant in a market full of other rational participants. Even the term "alpha" which you used makes little to no sense without EMH - why would people be so obsessed with finding alpha and beating the market if it was easy? If markets were really very inefficient, alpha would be a poor measure of success as it's just comparing you to a useless benchmark.
In fact, the existence of highly successful investment professionals like Mr. Buffett only helps the case for EMH, if anything. There's a reason why only a few investors are as highly respected as him, out of a pool of millions. It's because it's really hard to generate even a small amount of alpha, and for the rest of us, EMH effectively applies and we're better off just buying the market portfolio or giving our money to someone else to manage. Furthermore, if we assume that Buffett truly has some kind of competitive advantage over the market, it's no wonder that people have given him billions of dollars to work with; the more money he manages, and the more profit he makes, the more efficient the markets get, and the harder it gets to keep finding alpha using the same strategies.
No. You don't have to assume all market participants are rational. You can assume there's lots of people buying/selling at irrational prices. The EMH just assumes there's at least *one* rational deep-pocketed investor who will see this mispricing and then spend billions of dollars to take advantage of it, which will drive the price back to the correct level. You could assume almost everyone in the world is an idiot but as long as there is one Warren Buffet, prices would still rapidly tend towards efficiency.
No serious person thinks EMH is *instantaneously* true, obviously mispricings do occasionally happen. The realistic version of the EMH just says that if the mispricing is obvious, it won't take long before Warren Buffet or Ken Griffin notices and fixes it and then the price is efficient again. Markets may not be perfectly efficient, but it's clear that they rapidly *tend* towards efficiency, at least.
"EMHers" work in the risk department. The market has shown to be very efficient at removing them from the trading desk.
They're all fools
Equivalent of chicks believing in star signs.
The only practical implication of the EMH is just anytime you see a great obvious trade, ask yourself "if this stock is so obviously great, why hasn't some other hedge fund already noticed and bought all the stock already? Wall Street has 200,000 other people are all just as smart as me, so do I *really* think I'm such a genius that I'm noticing something all those other people missed? Or is possible that maybe there's some risk I'm not considering and it's not such an obviously great trade after all?"
If you have the resources and informational advantages of Citadel or RenTech, then maybe yes, maybe you really are the first to find that arbitrage. Citadel can assume prices are not always efficient. But if you're just some guy day-trading alone, then you have no advantage over Wall Street, and you really have to ask yourself why you think you're such a genius that you found something everyone else on Wall Street missed.
The people behind EMH (Fama etc) will be the first to tell you, it’s just a theoretical framework and not something they believe is actually the case in reality.
Now they do believe the market is closer to efficiency than maybe the average person thinks. They might say things like, it’s not a great use of time to acquire the necessary insights to beat the market because others are attempting the same, and you might find that effort fruitless.
But at no point will they say that someone who is truly exceptional in their ability to develop a thesis (intellect, work ethic, etc etc) can’t beat the market.
Some of their followers will say that, but that’s classic follower behavior. Followers are generally not as smart as originators, so they fail to appreciate the nuance in the belief system. There’s also just good old jealousy/cope at play . . people don’t want to believe that others can do what they cannot do.
Well said, Asness a student of Fama has written about the topic a lot last couple years.
Yes, Asness has been vocal about his thoughts on the efficient market hypothesis and its limitations. He has proposed that while markets may not be perfectly efficient, they still are difficult to beat consistently over time, especially after accounting for transaction costs and other fees. Asness's views and research continue to contribute to the ongoing debate about the role of efficient markets in investing.
It can't be purely Brownian because a Brownian motion of physical particles that always went in one direction (like how the market drifts upwards) would violate the second law of thermodynamics.
refuting academic theories
Short answer: If it weren't for the market participants, markets wont be random or Brownian. They drive the efficiency - they're NOT still investing and researching DESPITE efficiency.
Having this in mind, this leads to plenty of other very interesting questions/ theories/ paradigms. The more interesting ones include Grossman-Stiglitz paradigm, the active-passive tipping point (how many active players does the market need to maintain efficiency? Many researchers have come up with diff ranges for this question. Maubossin suggests that we are already approaching that range, and non-alpha generating active managers will be pushed out).
You also have to always remember that even the most diehard efficient theorists themselves, do not believe that prices are correct ALL THE TIME. Rather, they view it as only a theoretical framework (which is very useful to practitioners as well, for obvious reasons. Before building a position, ask yourself: 'What do I know that the market doesn't? What makes me think my thesis is not already priced in?').
Further to that, in this Damodaran lecture, he also explains that efficient theorists do not believe that prices are always correct nor that no one can beat the market on average, but only that the standard deviation of prices to true value are constant (or smtg along those lines, it's been a few months since I watched that lecture).
And to make things even more interesting, the BULK of the literature so far is only centered around the US market! (which is arguably the deepest and the most efficient market in the world) There are vast swamps of markets internationally, that still await further testing and refinement of the body of work
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