Refuted economic doctrines #1: The efficient markets hypothesis

by John Quiggin on January 3, 2009

Over at my blog, I’ve started a series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I’ve already posted and I’ll probably edit the posts in response to points raised in discussion. I’m crossposting here in the hope of getting more discussion, but readers who aren’t interested in econowonk stuff may want to skip this series.

Number One on the list is a topic I’ve covered plenty of times before (in fact, I was writing about it fifteen years ago), the efficient (financial) markets hypothesis. It’s going first because it is really the central microeconomic issue in a wide range of policy debates that will (I hope) be covered later in this series. Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets.

The hypothesis comes in three forms.

The weak version (which stands up well, though not perfectly, to empirical testing) says that it is impossible to predict future movements in asset prices on the basis of past movements, in the manner supposedly done by sharemarket chartists. While most of what is described by chartists as ‘technical analysis’ is mere mumbo-jumbo, there is some evidence of longer-term reversion to mean values that may violate the weak form of the EMH.

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. It was this claim that lay behind the proposal for ‘terrorism futures’ put forward, and quickly abandoned a couple of years ago. It seems unlikely that strong-form EMH is going to be taken seriously in the foreseeable future, given the magnitude of asset pricing failures revealed by the crisis.

For most policy issues, the important issue is the “semi-strong” version which says that asset prices are at least as good as any estimate that can be made on the basis of publicly available information. It follows, in the absence of distorting taxes or other market failures that the best way to allocate scarce capital and other resources is to seek to maximise the market value of the associated assets. Another way of presenting the semi-strong EMH is to say whether or not markets are perfectly efficient, they’re better than any other possible capital allocation method, or at least, better than any practically feasible alternative.

The hypothesis can be tested in various ways. First, it is possible to undertake econometric tests of its predictions. Most obviously, the weak form of the hypothesis precludes the existence of predictable patterns in asset prices (unless predictability is so low that transactions costs exceed the profits that could be gained by trading on them). This test is generally passed. On the other hand, a number of studies have suggested that the volatility of asset prices is greater than is predicted by semi-strong and strong forms of the hypothesis (note to readers – can anyone recommend a good literature survey on this point).

While econometric tests can be given a rigorous justification, they are rarely conclusive, since it is usually possible to get somewhat different results with a different specification or a different data set. Most people are more likely to form their views on the EMH on the basis of beliefs about the presence or absence of ‘bubbles’ in asset prices, that is, periods in which prices move steadily further and further away from underlying values. For those who still believed the EMH, the recent crisis should have shaken their faith greatly. But, although the consequences were less severe, the dotcom bubble of the late 1990s was, to my mind, are more clear-cut and convincing example of an asset price bubble. Anyone could see, and many said, that this was a bubble, but those, like George Soros, who tried to profit by shortselling lost their money when the bubble lasted longer than expected (perhaps long-dated put options would have provided a safer way to bet on an eventual bursting of the bubble, but Soros didn’t try this, and neither did I.)

More important than asset markets themselves is their role in the allocation of investment. As Keynes (allegedly) said in his General Theory of Employment Interest and Money,, this job is unlikely to be well done when it is a by-product of the activities of a casino. So, if the superficial resemblance of asset markets to gigantic casinos reflects reality, we would expect to see distortions in patterns of savings and investment. The dotcom bubble provides a good example, with around a trillion dollars of investment capital being poured into speculative investments. Some of this was totally dissipated, while much of the remainder was used in a massive, and premature, expansion of the capacity of optical fibre networks (the fraudulent claims of Worldcom played a big role here). Eventually, most of this “dark fibre” bandwidth was taken up, but in investment allocation timing is just as important as project selection.

The dotcom bubble was just one component of a massive asset price bubble that began in the early 1990s and is only now coming to an end. Throughout this period, patterns of savings and investment made little sense. Household savings plunged to zero and below in a number of developed countries (including nearly all English-speaking countries) and the resulting current account deficits were met by borrowing from rapidly growing poor countries like China (standard economics would suggest that capital flows should go in the other direction). The massive growth of the financial sector itself, which accounted for nearly half of all corporate profits by the end of the bubble, diverted physical and particularly human capital from the production of goods and services.

Finally, it is useful to look at the actual operations of the financial sector. 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. 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. I’ll leave it to readers to make their own judgements (maybe with some links when I get around to it).

Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. More to follow!

{ 32 comments }

1

OneEyedMan 01.03.09 at 2:29 am

This is a pretty weak indictment of the efficient market hypothesis. You grant that it holds in its weak form. You spend some time criticizing the strong from, yet I’ve never heard a financial economist claim that that hypothesis was true anyway.

If a semi-strong efficient market hypothesis (or even a weak one) held then the prices from securities in the market proposed by Defense Advanced Research Projects Agency would have valuable information content. They need not be strongly efficient.

The point about Albanian markets is well taken. The various EMH may hold in some assets and not others. However, that governments may sometimes do a better than markets in allocating resources strikes me as uncontroversial. Market failures, incomplete markets, and public goods can all cause this to occur, even if every asset market that does exist is strongly-efficient. The more important question is in any situation is it more likely that markets will provide the efficient allocation.

Using the dot-com boom and bust strikes me as an imperfect example.
Efficiency in a market is an ex-ante attribute, not an ex-ante one. Efficiency is a claim about the best possible allocation given given the information available at the time, not was there an investment plan that would have resulted in higher productivity today given information and states of the world revealed after the decision was made. I have had coworkers and friends who were participants in the technology boom and bust. 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.

2

P O'Neill 01.03.09 at 3:03 am

I share the skepticism about highlighting the dotcom boom. Of course it resulted in huge private losses, but that’s the nature of technological innovation. People bet a lot on the wrong horse or too much on the right one. But at least that boom left the world with some actual usable stuff. The property boom that came after it left us with some really big houses. In addition, I think it’s important that it was a policy decision to extend the dotcom boom into the property boom, by lowering interest rates so much once the dotcom boom collapsed (Osama bin Laden helped too).

But I take your larger point. The EMH is dead.

3

F 01.03.09 at 3:47 am

I’m fascinated by the similarities between the EMH and Intelligent Design. Both ideas are marked by anti-intellectualism wrapped in a thin veneer of supposed explanatory power. The anti-intellectualism is bolstered by the moral and practical failures of scientific determinism. Quantum mechanics proved we couldn’t predict anything, and eugenics proved that even trying to led us to evil.

These philosophies seem to say that I don’t have to study all of these complicated factors to know how things (either markets or nature) work. I simply have to recognize that they are automatically the ideal outcome of those complicated forces, and take the result without analysis (which smacks a bit of Leibniz). This saves me from having to be clever or insightful or analytic at all. No design or planning is necessary; it’s all been done. It appeals to both the lazy and the unintelligent.

4

chrismealy 01.03.09 at 3:48 am

When I took finance back in 1993 or so my professor chuckled about EMH. You know, like, “If you believe that sort of thing.” CAPM also produced chuckles.

I think a lot of EMH critics overstate how much support it ever had in the first place. But there are true believers out there. And people haven’t given up on beta as a measure of risk yet either, even though there was never a time when it made sense.

Value at risk has got to go too.

If you’re a newly-minted EMH skeptic, before you start messing with your 401k, remember there’s still a good reason to stick with index funds: costs.

5

j@ne futzinfarb 01.03.09 at 4:54 am

F-

I take strong exception to your interpretation (misunderstanding) of quantum mechanics. It emphatically did not prove that “we couldn’t predict anything”, not even in a lay presentation of its principles. Your “popular” misunderstanding of quantum mechanics advances the creationist/ant-intellectual agenda. Quantum Mechanics only established that it’s not possible to predict at the atomic and subatomic level what 19th century physicists thought they could – that “not only is the universe stranger than we imagine, it is stranger than we can imagine” (Eddington) . That you wrote and submitted your post using a computer based on semiconductor technologies is ample contradictory evidence to your hypothesis about what quantum mechanics predicts.

6

Canadian 01.03.09 at 5:42 am

The failure of the some of the most previously successful investment banks, banks and hedge funds (i.e. our most sophisticated financial institutions) implies that the EMH holds in its strongest form. If these firms could have predicted and avoided the crash, they would have done so. The damage these firms did to themselves and their shareholders is the strongest evidence for the EMH.

7

Seth Finkelstein 01.03.09 at 7:02 am

I’m out of my area of expertise, but it seems to me that the language being used here is confusing, given per above that “EMH” is being used for several different ideas – mathematical statements about price movements, and social statements about best policy. It’s a bit like saying the “Evolutionary Hypothesis” means everything from species change to Social Darwinism. In both cases, there are some narrow technical principles, and many ideologues trying to claim those technical principles as scientific mandates for their form of social organization. But using the same words for both cases is playing into the confusion.

8

flubber 01.03.09 at 8:16 am

“can anyone recommend a good literature survey on this point”

My finance class had us read:
Robert Shiller, 2003. “From Efficient Markets Theory to Behavioral Finance” and
Burton Malkiel, 2003. “The Efficient Market Hypothesis and Its Critics”

They’re only good for introductions to the subject, IMO. They were in Journal of Economic Perspectives, so for non-economists I think.

9

Kevin Donoghue 01.03.09 at 9:48 am

As Keynes (allegedly) said, this job is unlikely to be well done when it is a by-product of the activities of a casino.

Why “allegedly”? From the notorious Chapter 12 of the General Theory: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

10

steven 01.03.09 at 11:50 am

The logical implication is that a mixed economy will outperform both central planning and laissez faire

To be exact, the logical implication is that there exists a mix that outperforms both central planning and laissez faire, not that all mixes outperform both central planning and laissez faire.

11

Matt Heath 01.03.09 at 12:39 pm

Do prediction markets (like the terrorist thing) really rely on a strong version of the efficient markets hypothesis? I got the impression from Robin Hanson’s blog posts that the idea was to design simplified markets which only reward ones ability to predict and that similarly designed markets (whether in controlled experiments or things like Intrade) were showing their worth empirically by outperforming other form of prediction.

12

Alex 01.03.09 at 2:01 pm

If you relied on Robin Hanson, you’d probably give up cornflakes in favour of a refreshing breakfast dish of prediction markets. For a self-declared radical sceptic, he’s very convinced.

13

Matt Heath 01.03.09 at 2:45 pm

Heh, yeah. Actually, all those Overcoming Bias bloggers seem more convinced of some entertainingly weird stuff than they have any real right to be. Still, is there any reason why something like the terrorism prediction marking couldn’t be effective even if markets aren’t in general maximally efficient (a genuine request for knowledge; I have no expertise in this area).

14

Matt McIrvin 01.03.09 at 3:06 pm

Aren’t casinos themselves a pretty good refutation? Considered in terms of profit alone, the value for a player in the market for casino games is nearly always negative, yet casinos rake in money. Now you can, and people do, defend the EMH for casinos by arguing that the players are actually getting some form of utility apart from their winnings (the thrill of risk; the sights and sounds of the casino). But that raises the worry that exactly the same phenomenon could be at work in financial markets, where it isn’t generally taken into account in determining rationality.

15

Tim Worstall 01.03.09 at 3:35 pm

Hmm.
“and worse in others (those requiring long-term planning, for example).”

Are we really to take it that politicians looking as far as the next election are going to be better at long term planning than, say, a company with a 25-50 year planning horizon?

That, for example, Chavez is running Petroleos deVenezuela better than BP, Shell or Exxon are being run?

I agree that it’s possible, of course, but I’d have thought that it was unlikely.

16

Tim Worstall 01.03.09 at 3:47 pm

Sorry, should have pointed out that Statoil is a clear example of how a State owned industry can indeed be top notch. But I’m pretty certain that they don’t let the politicians anywhere near any operational decisions.

17

P O'Neill 01.03.09 at 3:52 pm

Or Aramco. But all the exceptions in the oil sector?

18

beezer 01.03.09 at 3:59 pm

The best representation of our current economic malaise came in the form of a TV Commercial by Comcast, advertising the technological swiftness of its cable network
First you have a common rabbit, which then takes a nice draught of Comcast elixer. The rabbit then transforms into something of a steroid version of rabbit. It then begins running, first morphing into a hairless rabbit (I suppose a rabbit version of advanced competitive swimming suits). Next the steriod, hairless rabbit is fitted with two jet engines. Then a fighter pilot pumped full of coffee is added. Then the whole contraption hurtles down a ski jump and across the winter sky “under better than optimal conditions.”
No need to show Mr. Rabbit’s landing site. Not pretty at all, I imagine. Most of us are not this rabbit. Unfortunately, our banker is–or was.

19

RM 01.03.09 at 4:06 pm

Although it is somewhat dated, the survey article you want may be: Stephen F. LeRoy, “Efficient Capital Markets and Martingales,” Journal of Economic Literature, Vol. 27:4 (1989), p. 1583.

20

dsquared 01.03.09 at 4:18 pm

Are we really to take it that politicians looking as far as the next election are going to be better at long term planning than, say, a company with a 25-50 year planning horizon?

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

21

OneEyedMan 01.03.09 at 4:20 pm

Prediction markets have proven useful in corporate decision making to estimate sales and profits, even when there was no expectation of any sort that the markets would be efficient.

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.

22

dsquared 01.03.09 at 4:41 pm

Prediction markets have proven useful in corporate decision making to estimate sales and profits, even when there was no expectation of any sort that the markets would be efficient.

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

23

geo 01.03.09 at 6:01 pm

Seth @7: there are some narrow technical principles, and many ideologues trying to claim those technical principles as scientific mandates for their form of social organization

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.

24

roger 01.03.09 at 6:05 pm

“Are we really to take it that politicians looking as far as the next election are going to be better at long term planning than, say, a company with a 25-50 year planning horizon?”

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.

25

OhNoNotAgain 01.03.09 at 10:14 pm

OneEyedMan,

“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.

26

Seth Finkelstein 01.04.09 at 12:39 am

As a professional programmer, I am sure that any success of prediction markets in “estimate sales and profits” comes not from technocapitalist mysticism, but rather from setting up a context where experts can realize a gain from giving the correct answer rather than a punishment. You could dispense with the whole mechanism and just ask the experts and listen to them. But executives tend to really avoid doing that.

27

Denis Drew 01.04.09 at 5:26 pm

I am currently from Chicago and my school says: the market is like a human body where every cell has a mind of its own and covets what all the other cells have — not the magical efficiency world the Chicago Boys fantasize.

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.

28

stigand 01.04.09 at 5:39 pm

@24: “there is certainly less turnover in political seats than there is in the upper management of companies”

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…)

29

roger 01.04.09 at 8:21 pm

stigand, excellent stab at quantifying this common canard. Of course, I was thinking that Worstall’s notion of politicians being defined by the elections they face excluded the ministers or cabinet secretaries, and put the onus on presidents and legislatures. Perhaps one wants a mix of the two. That a president in the U.S. has a pretty much guaranteed 4 years would seem to mean, on your stats, that he has about a year and a half less tenure than the ceo of a FTSE 100 company. On the other hand, there is the volatility factor – it is much more common, I imagine, for a CEO to step down or quit for a different job before the 5 and a 1/2 year mark than for the president to. However, when we turn to the legislature, and to the tenures of the heads of various committees, it seems that the stakes shirt decisively to the state. Average tenure in the house of Reps, according to C span, is 9 years, and in the Senate, 11. This implies a much greater time horizon than your average upper management type at the FTSE company.

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.

30

Tracy W 01.05.09 at 11:09 am

What you don’t mention is that Fama, the originator of the EMH, was well aware of bubble theory long before the latest financial crisis, as were financial economists generally. See this 1991 paper by Fama reviewing the evidence for and against 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.

31

Z 01.05.09 at 10:48 pm

The weak version (which stands up well, though not perfectly, to empirical testing) says that it is impossible to predict future movements in asset prices on the basis of past movements

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.

32

Tracy W 01.06.09 at 1:34 pm

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?

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.

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