Author Topic: Why I Think the Efficient Market Hypothesis is Wrong  (Read 8606 times)

hodedofome

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Why I Think the Efficient Market Hypothesis is Wrong
« on: June 08, 2014, 08:08:26 PM »
***I'd say most of the folks on this board are Bogleheads and there's nothing wrong with that. For most investors, you SHOULD be investing in index funds and you SHOULD NOT be trying to time the market or actively managing your portfolio. It should be the lowest cost portfolio you can find, the most tax efficient, and you should not be looking to become rich from the stock market. The way you become rich is by working your butt off, making lots of money and saving at least half of your income. The stock/bond market should just be there to allocate your savings to something that can provide an above-inflation return.***

That being said, I would like to share my thoughts on the EMH. I don't mind folks believing in it, there's plenty of evidence that it's valid. Yet there's plenty of evidence that it's not. I'd like to focus on the other side of the argument for this post.

The EMH basically states that investors are rational, that all information is immediately priced in, and there's no way to gain an edge without inside information. Strong forms of EMH says that even with inside information you still can't gain an edge. Yet there's plenty of evidence from people like Daniel Kahneman and Dick Thaler and others which shows that people are not always rational (just walk around Wal-Mart for all the evidence you need...). Kahneman showed that we have 2 systems that we use to make decisions - System 1 and System 2. http://www.scientificamerican.com/article/kahneman-excerpt-thinking-fast-and-slow/ System 1 is very quick and fast thinking but very emotional and takes lots of shortcuts. System 2 is much more rational, conscious, slow and long-term. Investors may make decisions very quickly and choose the option that is not very rational. If a market is nothing more than a bunch of investors, and investors make poor decisions all the time, how then is the market rational? When your uncle says he's cashing in his pension near the top of the market so that he can buy the high flying stocks of the day, only to watch his account plunge in the next bear market, how is that rational? How then can we say the market is rational when it's full of idiots like your uncle?

Larry Summers created a model of an alternate financial universe where investors weren't rational and prices didn't reflect fundamental values, and you couldn't tell the difference (statistically) from a rationally random market in a 50 year period. Only in 1,000 years of data could you tell the difference. Yet it is in the past 100 years or so of stock market data that economists and finance professors use to 'show' that markets are rational and random.

EMHers may then say that there's enough rational investors out there to keep prices in line, yet we see inefficiencies all the time that don't get worked out right away. Ed Thorp figured out the Black-Scholes option pricing formula a few years before anyone else did and used it to make a lot of money. He then figured out convertible bond arbitrage and even though others eventually caught on, he still made ~20%/yr returns on it for about another 30 years before enough hedge funds did it to make returns more in line with the market. It ends up being a predator and prey type of game, where an inefficiency pops up and everyone piles in, only to create new inefficiencies in the process.

When 3Com spun off Palm Pilot in 2000, there was a period of months where 3Com was was trading cheaper than the Palm shares they owned. This went on for months because arbitragers weren't able to find enough shares of Palm to short to bring the prices back in line. Information is immediately priced in to the stock? Not always. What happens when information is released, but funds managing billions of dollars want in or out of the stock? Can they immediately buy all the stock they want or dump their shares on the market? Heck no. Those guys take weeks or months to get in and out, which creates all sorts of trends that don't look 'efficient' at all.

Other evidence comes from the guys who created the EMH themselves. Their actions don't match up with their theories, or what they say is inconsistent with a dogmatic EMH philosophy. Paul Samuelson won a nobel prize for his work on the EMH, yet he was a large investor with Warren Buffet and helped found Commodities Corp. Commodities Corp was a breeding ground for some of the best active traders the world had ever seen at the time. Most guys became price-only trend followers - buying commodities that were rising and selling ones that were falling. This was about as far from a random walk as you could get.

Eugene Fama, the godfather of the EMH, for years stood behind his beliefs that investors couldn't outsmart or outperform the market. Part of this is my belief that because he was not able to beat the market, he's spent his life proving that nobody else can either. (He tried unsuccessfully to do this in college with one of his professors). Anyways, in the '80s and '90s, after looking at the data again, he realized that beta was not enough to explain prices of stocks. He then added value, small stocks and momentum to his model to explain prices. But wait, isn't value investing and momentum trading what all those 'active' managers were doing all those years in the first place? And how do you get to throw in all these new data-mined strategies into the rational, random-walk EMH and still call it the EMH? Must be nice to be the godfather! Not to mention, Fama has been an advisor to DFA which runs value funds not too much different from the actively-managed value funds run by EMH nonbelievers.

Michael Jensen, who at one time said "no other proposition in economics which has more solid empirical evidence supporting it than the EMH," had a friendly debate with Warren Buffett. After the debate, he said "One of the things I came away from that with was Buffett was one of the smartest people I've ever met, and wise. He could play on my turn without making mistakes. It's not by accident that he's worth billions." This is not a surprise to anyone who has followed Buffett, but this tells me that professors can stay behind the walls of their academic research and not look at the actual practitioners in the field. How can you be a staunch believer of EMH after you've spent time with Buffett, Soros, Ed Thorp or Jim Simons? To go from facts like most 'mutual funds don't outperform the market' to 'nobody can outperform the market' requires quite a bit of evidence.

And this we see with Fischer Black, who moved from MIT to Goldman Sachs - “Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles.”

Now, I think one reason we still have academics hawking the EMH is that they haven't come up with a better model than CAPM to explain prices. And the guys like Shiller, Thaler and Kahneman have poked a bunch of holes in the EMH but haven't come up with a model of their own. So the professors hold onto their beloved simple model that explains everything, even though it doesn't do a great job IMO. Fama is the worst, so desperate to keep his life's work intact that he'll never admit he might have been wrong. I give the EMH about 10 years after Fama's death before it's put to rest. I don't know what will be in it's place, perhaps just a consistent belief that markets get more efficient over time, but yet still has it's times of irrationality and inefficiency. However, just because that's the case, doesn't mean you can beat it. That is a very, very difficult thing to do.

Khan

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #1 on: June 08, 2014, 09:40:51 PM »
I think believing in strong EMH is crazy.

I however do support weak EMH, or the proposition "In the short term, the market is a voting machine. In the long term, it's a weighing machine."

Now, whether or not I or anyone here can actually profit off of that discrepancy is anyone's guess, but I would encourage anyone to take a look at the HLF longs who aren't rational, they're "true believers" that HLF isn't a pyramid scheme and that the earnings, regardless of source are absolutely sound numbers.

I can tell you one thing, since becoming an active investor, in 2011, I've lagged the bull market rally. I do have lower PE ratios and other metrics than the market though on most of my stocks, which makes me feel more comfortable.

butchmonkey

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #2 on: June 08, 2014, 11:29:19 PM »
Completely agree. Markets are not completely rational because people are not rational. But the costs of exploiting inefficiencies usually surpasses 


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butchmonkey

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #3 on: June 08, 2014, 11:36:52 PM »
...The gain to be had in the first place.

In other words the market is like capitalism. It ain't perfect, but it's the best pricing machine we've got.

In any case in practice the lesson could not be more clear. ;Invest passively in a low cost well diversified portfolio and be content to merely best 8 out of 10 investors.


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yuka

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #4 on: June 09, 2014, 06:43:52 AM »
Hopefully you won't find this too nitpick-y, but I think it's an important distinction. I would say that people are fundamentally rational, but we make our decisions from incomplete information, so from above things look irrational.

Mississippi Mudstache

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #5 on: June 09, 2014, 07:38:54 AM »
Markets are not completely rational because people are not rational. But the costs of exploiting inefficiencies usually surpasses the gain to be had in the first place.

This basically summarizes my thoughts on the subject, and probably many if not most of the folks here. I definitely do not believe that Warren Buffett became a billionaire by accident, but I do believe that the vast majority of people who think they can beat the market will experience a humbling 'reversion to the mean' at some point in the future. Index funds for me, thank you very much.

Franklin

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #6 on: June 09, 2014, 07:53:07 AM »
Quote
I however do support weak EMH, or the proposition "In the short term, the market is a voting machine. In the long term, it's a weighing machine."

Agreed.  If you are going to evaluate a company's fundamentals, come up with a target price, and buy when the price goes well below that, then you have to believe the market will recognize that valuation at some point.  Otherwise, why waste your time with the effort?

warfreak2

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #7 on: June 09, 2014, 08:15:48 AM »
Agreed.  If you are going to evaluate a company's fundamentals, come up with a target price, and buy when the price goes well below that, then you have to believe the market will recognize that valuation at some point.  Otherwise, why waste your time with the effort?
Not necessarily. You still get the company's earnings, even if they don't pay dividends or do stock buybacks. If you're literally the only one who notices that the company is solid gold, everyone else will happily sell to you below the true value, above the "market price". You will become the majority stakeholder, and if you want to, you can pass a motion to distribute earnings at the next AGM.

Theoretically, anyway. You might have to borrow a lot of money to afford 50% of the shares...

sol

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #8 on: June 09, 2014, 08:37:32 AM »
I don't think anyone believes in the perfect ideal of the EMH.  If that were literally true, no one would have ever been convicted of insider trading.  And there would never be a stock bubble or a market crash.

Of course markets have temporary inefficiencies.  Of course there is incomplete information available.  And of course manipulators like cable news shows can pump up a stock by publicizing it to a wide audience of gullible people.  But I don't think any of those disprove the efficient market hypothesis.

warfreak2

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #9 on: June 09, 2014, 08:57:10 AM »
The EMH at least gives a good baseline that you have to be able to argue against when you think you found a brilliant opportunity. Perhaps you did find a brilliant opportunity, but you have to prove to yourself that the market really is inefficient. You have to have a good, robust reason why other people came up with the wrong price.

If you discover the Black-Scholes formula, and nothing similar has been mentioned in the academic literature, then you probably have a real market inefficiency if you keep the formula secret. But if you are shorting the S&P 500 because "it's too high, so it's gotta crash soon", you don't really have any evidence that the market is inefficient, beyond the fact that other people value it differently to you.

arebelspy

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #10 on: June 09, 2014, 09:00:22 AM »
I don't think anyone believes in the perfect ideal of the EMH. 

+1.

I don't think anything stated in the OP was controversial.

As I posted in another thread recently:
I agree. Although I believe in  a pretty weak EMH, cause I am hard pressed to reconcile  bitcoins, 1999 internet stocks, 2007 real estate, Q4/08-Q2/09 stock prices, with a very efficient market.

Irrationality in the moment can override, but due to the efficiency it pretty quickly* gets back to a rational valuation.

I think it was the market being efficient that caused a coming to earth of 1999 internet stocks, 2007 real estate, 2008-2009 stock prices to bounce back, etc.  In other words, that reversion to the mean is partially from the efficiency of the market.  When it gets too far over- or under-valued, the market adjusts to fix that.

*Depending on your definition of pretty quickly.  It can stay out of whack for a few years, hard to imagine it taking longer than that, given the speed at which things move today, but having said that I fully expect to get burned by that quote years from now.  :D

The Benjamin Graham quote Khanjar said above says it perfectly.
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nordlead

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #11 on: June 09, 2014, 10:46:52 AM »
When your uncle says he's cashing in his pension near the top of the market so that he can buy the high flying stocks of the day, only to watch his account plunge in the next bear market, how is that rational? How then can we say the market is rational when it's full of idiots like your uncle?

rationality (in game theory, which is what you are discussing with EMH) only means that given the information the agent (or person, whatever) will make the decision that will maximize their utility (or payoff).

So, assuming the uncle did some research and believed the stocks would continue to rise, then he was acting rational. He could also be acting rational if leaving the pension provided great emotional utility.

You have a better argument saying that rational entities are poor utility evaluators.

blackomen

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #12 on: June 09, 2014, 11:20:30 AM »
The nice thing about index funds is that you can get average performance with zero skill in investing.

Also, as mentioned, the market being inefficient is one thing but actually being able to consistently exploit these inefficiencies for gains is another story...
« Last Edit: June 09, 2014, 11:22:07 AM by blackomen »

dragoncar

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #13 on: June 09, 2014, 11:42:14 AM »
+1 to everything said here, but I'll add in my own little conspiratorial note (although I'm not really a conspiracy theorist).  EMH may state that free markets are efficient, but of course our markets aren't always completely free.  As mentioned above, insider trading and market manipulation do in fact exist.

waltworks

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #14 on: June 09, 2014, 12:48:04 PM »
I actually basically agree (though I'm one of the usual "you can't beat the market" crowd) with the caveat that I think the bar for beating the market (note that I mean *once you include expenses*) with skill is so high that 99% or more of small investors can't and won't.

Because people aren't all that rational all the time, they:
-Tell everyone on the internet when they're kicking butt and don't make a peep when they're losing money.
-Tend to remember their wins better than their losses.
-Seek out information that confirms their existing beliefs (ie "I can beat the market") and avoid information that contradicts them.
-Enjoy (in some cases) the adrenaline associated with any high-stakes activity.
-Have great emotional difficulty sticking with a strategy consistently when lots of money is being lost or made.

Taking all this into account, IMO the answer to a message board question about what to invest in should *always* be "index funds". If you need to ask anonymous strangers online, you should not be playing the market. Period. Whether or not very sophisticated folks with a lot of time, money, and appetite for risk should is an interesting academic question, but I'm assuming those people aren't looking to the internet for that sort of advice.

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smedleyb

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #15 on: June 09, 2014, 01:21:28 PM »
Of course it's wrong.

Being able to predict and profit off the mis-pricing of assets is an entirely different battle, one most individual investors who take a short term approach to the markets are destined to lose over the long haul.

Khan

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #16 on: June 09, 2014, 10:45:11 PM »
-Tend to remember their wins better than their losses.

I actually remember my losses, and my lost gains far better than I remember my wins.

Leisured

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #17 on: June 15, 2014, 04:05:13 AM »

I think that stock markets are efficient most of the time, because most people who invest are fairly rational. But on rare occasions, a king wave of madness and unreason rolls towards the shore, and a new population of ignorant, irrational investors (I use the term investors loosely) overwhelm the market through numbers.

I lived through the 1987 stock market crash in Australia, the same you had in the USA of course. I had started investing in earnest in the early eighties, but by about 1985 price to earnings ratios were getting high, and dividend yields were getting low, so I stopped buying. I suspect that I was part of what I call normal investors, and we were overwhelmed by the barbarians who know nothing about return on equity and only knew of the long stock market boom and wanted to hitch a ride. I, of course, continued to do nothing.

I rode out the crash, and even if the depth of the crash many of my stocks were at or above the price I had paid for them. People at the time commented that in spite of the clamour and tumult, the ‘real economy’, as stockbrokers say, kept steaming ahead.

The barbarians had bought high and sold low, as barbarians always do, and now, disgusted at their losses, left the market. Normal investors crept out of hiding, and efficient markets returned.

Think of ‘A Midsummer Night’s Dream’, near the end of the play, where the sun comes up and the spirits and creatures of the night flee away, and life returns to normal.

kyleaaa

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Re: Why I Think the Efficient Market Hypothesis is Wrong
« Reply #18 on: June 16, 2014, 02:23:35 PM »
Well, the EMH doesn't actually assume investors are rational. It allows them to be 100% irrational ALL of the time. It merely states that markets behave AS IF investors are rational. It makes sense if you think about it: if one investor is irrational in one way, there will probably be some other investor irrational the other way to balance them out. So long as the market in aggregate behaves rationally, it doesn't really matter whether any investors out there actually are. So I don't see Kahneman's research as particularly relevant here.