We can’t on an individual basis. We can however count the number of people who “reliably” beat the market, count the number of people who try to beat the market and failed, work out the proportion that would beat the market by pure chance, and see if the proportion of investors who beat the market in reality do better than we would expect by pure chance.
To give a simple example, we are going to test if people can predict if the sharemarket is going to go up or down, and we’re going to test this over four time periods. Now, if the sharemarket is a purely random walk, each time period it has a 50% chance of going up or down compared to its starting point. So if we tossed a coin on the basis of “heads” the market goes up, “tails” the market goes down, and the coin was fair, the coin toss would produce the right forecast 50% of the time. Tossing the fair coin twice would produce the right forecast 25% of the time. Tossing the fair coin four times would produce the right forecast 6.25% of the time. So if we look at 100 investors’ track records over four market predictions (just straight up or down), we would expect on average to see about 6 to 7 investors getting the right forecast each time if they were doing so by pure chance. It is possible of course that more than 7 or less than 6 investors could get the forecast right by pure chance, but the higher the number of investors who get it right, the less likely that this was due to pure chance. Then you find your 100 investors, and count their success rate by your criteria and see how many did.

There are a lot of complications in this approach that I have skimmed over, firstly how to calculate the confidence level for a given number, secondly, there’s a survivorship bias in retrospective studies (the investors who fail early on tend to leave the market), thirdly you can measure actual money return, not just my simple example of up or down, fourthly you can define success not as right every time, but as right x percent of the time and work out the probabilities of etc.

Another method is to challenge those who believe they can predict future movements on the basis of past movements to a contest comparing how well they do against a naive investor (a blindfolded journalist throwing darts at a list of stocks, that sort of thing), and see how they do over a set period of time. Or you can give the chartists data from actual stock movements and data from purely random series and see if they can distinguish reliably between the two. This gets around the survivorship bias but you generally can only get smaller numbers to participate so you can have less confidence in the data.

The failure of more people to do better on these sorts of tests than we would predict they would by pure chance is the strongest support for the weak version of the EMH, even though we can’t eliminate the possibility that a given successful investor was that way not by pure luck but by predicting future movements based on past movements.

If you want to learn more about how financial economists test the weak and semi-strong forms of the EMH empirically I suggest getting out the book “A Random Walk Down Wall Street” as a start. If you are very enthusiastic I suggest signing up for a statistics course.

I must say that I have an epistemological problem with this statement. How can it be tested experimentally? To wit, how do we distinguish someone who reliably beats the market (and such people certainly exist) because they are lucky from someone who does because he predicts future movements on the basis of past movements? And if anecdotal data point are not considered important enough, and only general trend are permitted, isnt’t it a bit like saying “On average, you cannot beat the average”? Anyway, I must be missing something so I would gladly read an hypothetical providing evidence for or against the statement of the weak EMH.

http://student.bus.olemiss.edu/files/Riley/FIN%20633/Market%20Efficiency/More%20Articles/Fama%201991%20JF.pdf
Sadly this electronic version isn’t searchable, but see pages 7 to 12 by the pdf count for a discussion of bubbles.

Even I was taught about rational bubble theory at university before the popping of the dot com bubble (basically, rational bubble theory is based on the “greater fool” idea, that it can be reasonable to buy an asset you think is overvalued if you believe that someone else will buy it off you for even more, a belief that leads to a run away bubble. The theory is unsatisfactory in that it doesn’t explain how the bubbles get started initially, but it does explain how they grow). I don’t think that many people form their views about EMH based on their beliefs about the existence or absence of bubbles, there are presumably some people who did on this basis, but in my admittedly random experience most financial economists do manage to argue for some interpretations of the EMH while noting the existance of bubbles – my lecturer at university being one example, Fama being another.

The strong version, which gained some credence during the financial bubble era says that asset prices represent the best possible estimate taking account of all information, both public and private. … .

Nor was it taken particularly serious by Fama, at least. This issue was discussed in the Fama paper in 1991, start on page 30 by the pdf count. Basically, long before the current financial crisis, Fama was unsurprised by research proving that you could beat the stockmarket by insider trading. (This is not to say that it was worthless doing that research, if it turned out you couldn’t that would have been very surprising, and every now and then scientific research does throw up extreme surprises).

It was this claim that lay behind the proposal for ‘terrorism futures’ put forward, and quickly abandoned a couple of years ago.

Well, it depends on who you talk to. From the Statement on Prediction Markets, signed by people including Kenneth Arrow and Robin Hanson:

Prediction markets reflect an old thought that underlies the price system: Information is widely dispersed in society, and it is highly desirable to find a mechanism to collect and aggregate that information. These markets work for several reasons: First, almost anyone can participate. Second, people think hard when they have to back up their predictions with money; buy the right presidential contract and you win, buy the wrong one and you lose. Third, the profit motive encourages people to look for better information.

One can believe that markets are a mechanism for collecting and aggregating information by producing a price, and the profit motive encourages people to look for better information, without needing to believe any form of the EMH.

For those who still believed the EMH, the recent crisis should have shaken their faith greatly.

The EMH isn’t like a religious cult for which you sign up for everything at once or nothing at all. Fama himself in his original form identified three different versions of the EMH, which you discuss, with varying levels of belief in each one. And well before the current financial crisis people were starting to discuss markets in terms of relative efficiency, like engineers talk about something being 45% efficient or 48% efficient, though I don’t know of anyone who figured out the metric to be able to do numerical calculations, with the exception of being able to measure how fast prices respond to news.

Even the strongest advocates of the EMH would not seek to apply it to, say, the Albanian financial sector in the 1990s, which was little more than a series of Ponzi schemes.

I think you underestimate the pig-headedness of researchers. If they could get a paper out of it, someone likely would (I have no idea how easy it is to get detailed financial data on the Albanian financial sector, as compared to the NY stock exchange, this availability does bias research, and then there’s the detail that most of the money available for financial research is in the USA and responds to this issue).

They would however want to argue that the massively sophisticated global financial markets of today, with the multiple safeguards of domestic and international financial regulation, private sector ratings agencies and the teams of analysts employed by Wall Street investment banks is not susceptible to such systemic problems, and is capable of correcting them quickly as they arise, without any need for large-scale and intrusive government intervention.

Knowing some people who make me look like a red-flag-waving commie, they are not arguing this, they are in fact arguing that financial regulation and fiscal policy, in particular the low interest rates, caused the financial crisis.

I’m trying to keep an open mind on this and balance out my emotional attachment to markets versus government. Nor am I an expert in the financial field. But this post by John does misrepresent the state of the debate about bubbles in the argument about EMH before the financial crisis, and indeed before 2000. And he talks about EMH as it was one entity, in which you either believe or don’t, while from its very inception it was more complicated than that.

This, of course, makes a lot of sense. The problem with government planning is not that it is short term and variable, but that it is long term and subject to obsolescence. Which doesn’t make it bad, but does characterize what one should look out for. I am hoping that we are on the verge of massive state ‘intervention’ in the economy; eventually, I am sure, the programs that might be set up – for instance, optimally, to encourage green transportation – will outlive their usefulness, or have to be reformed and overhauled. This strikes me as sure a bet as the bet that many of the FTSE 100 corporations will not be here in 50 years. Destruction, creative or otherwise, will strike all economic institutions sooner or later.

This is an interesting question. According to The Guardian (http://www.guardian.co.uk/media/2006/may/18/tvandradio.features11
), UK government ministers spent an average of 2.5 years in a single post in the Blair government, up from 2.3 years in Thatcher’s government. The average total length of a cabinet ministerial career was 4.7 and 4.3 years respectively (not clear if this means career in the cabinet or total ministerial career of ministers who at some point served in the cabinet).

Accordingly to a Finance Week survey from 2008 (http://www.financeweek.co.uk/item/6111), the average FTSE100 CEO has a tenure of 5 years 5 months.

I’m sue we can come up with a more accurate comparison. After all, the CEO numbers above are a point-in-time average, not a survey over a period. And perhaps we should weight the ministerial numbers to reflect the (longer?) tenure of the most senior politicians (PMs, CHXs…)

Timely example? A dozen years ago, I paid $500 for a root canal in a prime location office—about $750 in today’s money. Now the country wide price (I checked in hopes of lower) is $1400—almost double. Mmm. Over that time period medical insurance at least doubled (while doctors are doing three times as much—so much they cannot even charge us enough to cover it all?). Could dentists have wondered if they could get away with doubling their fees for doing the same thing and possibly get away with it because they would just seem to be to be going with the ever higher price medical flow?

A special Chicago Boys disconnection with reality is the labor market. Everybody understands that when more want to sell than buy it is a buyers market. The Chicago Boys don’t at all get the need to virtually reduce the overwhelming number of sellers in the labor market via effective unionization (effective in the era of the race to the bottom can only mean sector-wide) and/or as high as practicable a minimum wage so that the share of the pie gotten by most people is based on their genuine utility, not powerless desperation. Let’s at least say the Chicago Boys don’t differentiate between the efficiency of utility and desperation.

“Most believed that productivity was going to surge as a result of these developments and that consumers were going to go wild over the new services. If they had been right the prices would had been justified. Those beliefs turned out to be wrong, but you can’t conclude after the fact that they were misinformed.”

I most certainly can conclude so. They believed these things because they either purposefully didn’t look further than the tip of their nose or they were ignorant of the actual situation. Either way, they let their “beliefs” cloud rational decision making. Just look at the examples of some of the dotcom failures. It was apparent to anyone with half a brain that many of them would never reach revenues that would justify their valuations and the amount of money being poured into them. It was a scam by the banks and the investment groups that took these companies public:

1) Buy up a bunch of preferred shares of a company.

2) Hype the IPO like crazy, lying through your teeth about how the company actually intends to make a profit.

3) Turn over the shares as soon as the IPO is complete and the stock soars, leaving the rest of the suckers holding the bag.

I own a software company. We have never had more inquiries from people wanting to take us public than during that time, and most of them were neither interested nor cared about what it was that we actually produced. The “product” was the IPO stock, not anything we sold or provided as a service. I told them all to piss off.

I’m not sure what this could possibly mean. If companies in some impossible past, say 1950, too a 50 year planning horizon, by the time shareholder value became a slogan and LBO’s became popular ways of making companies more “efficient” – by loading them up with debts accumulated by their purchasers – the horizon was more like the next three quarters. Meanwhile, politicians spend very little time micromanaging the programs they vote in. This isn’t necessarily good – Bush’s expensive elderly pill program, which served as a vast rentseeking devise for fat pharamaceutical companies, could certainly have used some changes. Generally, the charge against government programs is that they are prone to inertia, not that they are prone to sudden mutability.

It is, to say the least, an odd charge that politicians don’t plan except for the next election – there is certainly less turnover in political seats than there is in the upper management of companies.

This seems to me (perhaps because, like Seth, I’m over my head with the technical stuff) an awfully important point. After all, Phil Gramm, Newt Gingrich, Grover Norquist et al didn’t care a fig about the evidence for the Efficient Markets Hypothesis, in any form. They just wanted a plausible-sounding excuse for shoveling more money at rich people.

Much, much less actual evidence of this than people like to claim.

The price becomes an information aggregation mechanism. It helps aggregate what everyone who will participate knows, which is often valuable and good enough. It doesn’t have to be an unbiased estimate, or even particularly close to the true value. Sometimes knowing something within 5% is enormously valuable, as is seeing a spike.

Tim, you’re going to have to shut up either about this or about nuclear power, your choice.