The Efficient Market? Not feeling it.

[Ron Scott]

The efficient-market hypothesis concludes that “asset prices reflect all available information”. So it is impossible to beat the market consistently since market prices should only react to new information.

I do think beating the market consistently is almost impossible, but I didn’t need this theory to get there. I’m not really sure what purpose it serves.

It seems to me the market is heavily driven, at least in the short term, by quarterly results, the strategies of larger investors and institutions, and by emotional reactions to single events, that pass quickly and are followed by different reactions to new events. (Remember the Kamala Crash from last week LOL?) The idea that the market reflects and is only reacting to collective “information” is a bit far fetched to me.

What do you think?

[Laura33]

I think it's largely crap.  Yes, a rational investor will value a stock based on all available information.  But not all information is available to everyone, and not everyone has the skills to interpret the information available to them.  Which means the deck is stacked in favor of the people with the most information and the most ability to interpret it.

Plus I think the idea of a "rational investor" -- as someone being driven purely by an objective, logical assessment of value -- has been well and thoroughly debunked.  Everyone has their own blindspots, biases, and emotional reactions.

The reason the efficient market hypothesis generally works more often than not is that when you apply it across an entire market, many of these gaps cancel each other out; if someone is selling low based on partial information, someone else with better information will snap that up; for everyone selling out of fear, there's someone buying out of greed.  Yes, there are collective manias in both directions that take over for a while, but those always settle down.

But that's the same reason the hypothesis does not hold up for any particular individual.  A lot of folks assume that they're the ones with the best information and best analytical skills, and are acting logically and unemotionally.  And a lot of those people are wrong.

[FINate]

Well, it is an unproven hypothesis. And you're not the first one to raise this criticism as many have argued investors aren't entirely rational.

In your last paragraph you write: "It seems to me the market is heavily driven, at least in the short term, by quarterly results, the strategies of larger investors and institutions, and by emotional reactions to single events, that pass quickly and are followed by different reactions to new events."

I'll point out that events are information. You can argue investors overreact, which is a fair point. But how do you know when you've found inefficiency/irrationality in the market? Similarly, how does one know which fund managers can consistently find inefficiency?

IMO this is the point of the EMH -- you can't know w/o the benefit of hindsight. So when we look at the performance of active fund managers, accounting for survivorship bias, we can see they are no better than randomly selected portfolios.

So while I believe there's inefficiency in the market, I'm convinced very few have the skill and discipline to exploit it. And even for those that have these qualities, the amount of effort required means they are essentially trading hours for dollars -- i.e. even if they do everything correctly the upside is limited.

For individual investors then, a Mostly Efficient Market (if we can call it that), means we cannot consistently compete with hedge funds and big finance to find and exploit small and short-term inefficiencies. We simply do not have the resources and preferential trading positions.

[reeshau]

Paul Samuelson said in 1998 that the market is "micro efficient" but "macro inefficient."  Meaning, the market will quickly digest things like company earnings and guidance, acquisition events, layoffs, etc.  But anyone directly tying a day's market moves to a single cause--future Fed moves, carry trades, geopolitics, the election, etc.--is over-simplifipying to the extent of being useless.

Myself, I do think the market is efficient...eventually.  I am a long-term investor in individual stocks.  I make my money on panics and ignorance.  Last March, with the regional banks, was a feast!  And homebuilders have done great, after 14 years in the wilderness; the pandemic boosted that into overdrive--a lucky break!  But if I didn't think the market would eventually come to its senses, there would be no point buying.

I think it's about time for a Buffett-ism:

"I’d be a bum on the street with a tin cup if the markets were always efficient.”

[twinstudy]

The point is not that markets are always efficient or that actors always have perfect information/rationality (they clearly don't), but that a market allows aggregation of many people's information. If you ask 100 people to guess how many jellybeans there are in a jar, the average of their guesses is likely to be close to the mark.

[dividendman]

"In the short run, the market is a voting machine, but in the long run, it is a weighing machine." - Graham

[Glenstache]

With friendly sauce:
https://letmegooglethat.com/?q=Behavioral+Economics

Any true economist worth their salt will acknowledge that teh perfectly efficient market and rational actor is a useful concept for teaching ECON 101, but quickly falls apart in the real world. See also comparative advantage falling apart in the wake of government subisidies to industrial sectors (China, writ large, etc. ).

... we could also discuss the misinterpretation of Adam Smith's invisible hand, but that is a parallel track.

[Ron Scott]

Paul Samuelson said in 1998 that the market is "micro efficient" but "macro inefficient."  Meaning, the market will quickly digest things like company earnings and guidance, acquisition events, layoffs, etc.  But anyone directly tying a day's market moves to a single cause--future Fed moves, carry trades, geopolitics, the election, etc.--is over-simplifipying to the extent of being useless.

I agree with you AND you made me laugh.

Every business day the market either goes up or down…and every day the good people on Bloomberg can immediately tell me the specific reason(s) for the jump or decline. Usually they know by noon!

[vand]

Surely aren't questioning the integrity and stockpicking brilliance of the men and women who run your country?

https://finance.yahoo.com/news/members-congress-outperformed-p-500-182024981.html

[nereo]

Surely aren't questioning the integrity and stockpicking brilliance of the men and women who run your country?

Interesting graph vand. Why does it only show 7% of Congress though. How did the other 490+ members do in 2023 compared to SPY?

[clarkfan1979]

Ray Dalio at Bridgewater outperformed the market with his fund "Pure Alpha". It's averaged 11.4% since 1991. They spend 100 million/year on market research.

Looks like the S & P 500 did about 9.9% since 1991. They spend 100 million/year to get an extra 1.5%/year.

For an average investor, it makes more sense to cut your budget by 1.5% and invest it than trying to beat the market by 1.5%. That is reserved for the world's best.

[vand]

Surely aren't questioning the integrity and stockpicking brilliance of the men and women who run your country?

Interesting graph vand. Why does it only show 7% of Congress though. How did the other 490+ members do in 2023 compared to SPY?

[Of the] 100 members of Congress who reported financial transactions this year beat the S&P 500...

"Republicans earned an average of 18% returns on their trades, while Democrats earned 33%"

I mean, I don't know what that says about the politics, but clearly Nancy Pelosi has been wasting her talents in Congress should be at a Hedge Fund.

And let's not even mention that time a certain future First Lady made a x100 return on cattle futures. oh.. go on then.

[nereo]

Interesting graph vand. Why does it only show 7% of Congress though. How did the other 490+ members do in 2023 compared to SPY?

[Of the] 100 members of Congress who reported financial transactions this year beat the S&P 500...

"Republicans earned an average of 18% returns on their trades, while Democrats earned 33%"

I mean, I don't know what that says about the politics, but clearly Nancy Pelosi has been wasting her talents in Congress should be at a Hedge Fund.

And let's not even mention that time a certain future First Lady made a x100 return on cattle futures. oh.. go on then.

Look, I'm a big supporter of ending all active trading for members of congress, SCOTUS and high level executive positions.  Full support. But the bottom line is that being a member of congress doesn't preclude them from trading.

...but your graph followed by your commentary comes off as highly prejudiced.  Why show only 38 if there were 100 members who reported financial transactions?  Why fixate on Nancy Pelosi over those who performed better and/or were also in high seats of power (e.g. Scalise, Schumer or McConnell perhaps).   McConnell somehow *under* performed SPY despite being the Minority leader of the senate and who's on the appropriations committee that decides a big chunk of where the fed spends its trillions.

If the GOP who reported actually did average 18% and the SPY 24.8%, wouldn't that mean they under-performed despite having seemingly as good information as Dems?  Does that mean they are incompetent or that this data isn't representative of the larger picture?

At first glance one might conclude "holy crap Higgins (D-NY) is off-the-charts!", but seems like his entire trading was < $100k and gains were largely buying NVDA at the "right" time.  Could be insider trading, could be  dumb luck. Others traded 100x his volume, including Green (at #2).

[GuitarStv]

I'm also fully for ending all active trading by members of congress.  It's ridiculous that they have insider information and can make money based on that.  This isn't a partisan problem - both sides of the aisle have access to the same sorts of information.

[Ron Scott]

I'm also fully for ending all active trading by members of congress.  It's ridiculous that they have insider information and can make money based on that.  This isn't a partisan problem - both sides of the aisle have access to the same sorts of information.

Why is this even an issue for godsakes…? Amazing.

[FINate]

Here's an interesting and recent interview with Fama, the creator of EMH: https://www.ft.com/content/ec06fe06-6150-4f39-8175-37b9b61a5520

Some of interesting and relevant quotes for this thread:

“When people ask me what I think about behavioural economics, I just say that all of economics is a behavioural science. The difference is whether you think the behaviour is irrational or rational.”

Fama is surprisingly phlegmatic when it comes to defending his life’s work, echoing the famous British statistician George Box’s observation that all models are wrong, but some are useful. The efficient market hypothesis is just “a model”, Fama stresses. “It’s got to be wrong to some extent.”

“The question is whether it is efficient for your purpose. And for almost every investor I know, the answer to that is yes. They’re not going to be able to beat the market so they might as well behave as if the prices are right,

[Laura33]

“When people ask me what I think about behavioural economics, I just say that all of economics is a behavioural science. The difference is whether you think the behaviour is irrational or rational.”

Well that seems rather to miss the point.  Everyone acts rationally.  It's just that they are acting rationally according to the information available to them and the hopes/fears/expectations/circumstances that make up their world view.  I mean, payday loans are economically irrational.  But if you have no food on the table and the rent is due, getting a little bit of your money now instead of more later makes a lot more sense than it does to someone tsk-tsk-tsking about the irrational poor while eating their own dinner in their comfy warm house.

Dismissing those kinds of things as "irrational" behavior ensures you will never actually understand it, which in turn means you will miss key factors in any analysis, policymaking, etc.

[twinstudy]

I'm not sure you can say everyone acts 'rationally'. I mean, your payday example might tug at the heartstrings, and certainly in an acute pinch one might need to resort to payday loans, but what about the time in-between? It would be more rational to work more hours, up skill, cut expenses, go to a bank to get a personal loan, or educate oneself. Sure, you can find reasons why a given person might have none of those options available, but that's not always going to be the case.

Likewise, why do people sit at a pokies machine throwing in hundreds of dollars? Obviously due to the dopamine rush. Is it rational though? You can get a dopamine rush doing all sorts of things. If you want, you can stock trade and get the same dopamine rush, except with a mildly positive EV instead of a strictly negative EV. Again, not really rational.

Finally, in a market system, if only some actors are rational and others are not rational, the market scheme will suffice to incentivise rational behaviour, and build a functioning system. That's what we have. No one is perfectly rational, but there are plenty of us who understand EVs, who know what variable ratio reinforcement is (and how to avoid bad examples of it), and who invest rationally. That is enough to build a functioning system.

[Laura33]

I'm not sure you can say everyone acts 'rationally'. I mean, your payday example might tug at the heartstrings, and certainly in an acute pinch one might need to resort to payday loans, but what about the time in-between? It would be more rational to work more hours, up skill, cut expenses, go to a bank to get a personal loan, or educate oneself. Sure, you can find reasons why a given person might have none of those options available, but that's not always going to be the case.

Likewise, why do people sit at a pokies machine throwing in hundreds of dollars? Obviously due to the dopamine rush. Is it rational though? You can get a dopamine rush doing all sorts of things. If you want, you can stock trade and get the same dopamine rush, except with a mildly positive EV instead of a strictly negative EV. Again, not really rational.

Finally, in a market system, if only some actors are rational and others are not rational, the market scheme will suffice to incentivise rational behaviour, and build a functioning system. That's what we have. No one is perfectly rational, but there are plenty of us who understand EVs, who know what variable ratio reinforcement is (and how to avoid bad examples of it), and who invest rationally. That is enough to build a functioning system.

Would it make more sense if I said "internally rational" or "rational to them"?  The point is that everyone thinks their decisions are rational, even when others may think they're ridiculously stupid.  I can think of two specific incidents in which I made decisions that I thought through in detail, that seemed perfectly rational at the time, and yet when I looked back later, all I could think was "wtf was I thinking?!?!"  One of which was, literally, going back inside my house when it was on fire to log off a conference call.  Seriously.  WTAF?? 

The reason I think it matters is that when you assume there's this objective dichotomy between "rational" and "irrational," you miss important things.  Because "irrational" basically means "we have no idea what they're thinking," so there's no point in trying to figure it out.  And that leads to bad policy.  Like, say, the marshmallow study -- interpreted to mean poor kids have no self-control, when in reality it is eminently logical to eat the single marshmallow as soon as it appears when your life experience tells you that good things get snatched away unless you use/hide them fast enough.  The problem is that study got extrapolated to "poor people are poor because character flaws," which leads to either nanny-state "must make decisions for them because they can't be trusted to do so," or conversely, "it's their own damn fault and we shouldn't encourage bad behavior, so let them fend for themselves."  When in reality the causes of poverty are much more complex -- not just financial, but cultural, racial, environmental, geographical, legal, you name it. 

Economic theory is fine as far as economic theory goes.  If you want to talk about the Rational Man in the context of the stock market, great.  But over the past c.40 years, economic theory has pervaded many, many aspects of our society and has become a significant policy driver.  And if you want good policy, you need to ask "why does this decision appear rational?" instead of just dismissing it as irrational. 

[FINate]

I think there's a common misconception that economics is about the study of money and/or financial assets. It's really about the study of values and the trade-offs involved in a value system. Money (and other fungible assets) just happen to be a good proxy for expressing value.

Dumping money into a slot machine is not rational if one values money and understands the law of large numbers. But it makes perfect sense if one values the feeling of dopamine hits. (Aside: I prefer to get my hits naturally via fishing where the house is not stacked against me).

Many of my peers thought I was nuts to leave a very large chunk of unvested stock options when I retired from tech. Yet this was rational for me because I value money less than my time, faith, and community. The trade-offs were well worth it to me.

[twinstudy]

Deprecating the value of the marshmallow study is in vogue right now, because the modern data shows that the correlations shown in the original marshmallow study are reduced or eliminated once you control for family income or cognitive ability. But what can we conclude from this? Nothing.

The fact that family income has a bearing on delay gratification might mean that children growing up in richer environments have more faith in future outcomes and therefore tend to discount future rewards less. Or it might just mean that self-regulation is important in succeeding financially and that parents who do so either pass on genes or teach children in a way that replicates the parents' qualities. In the latter case, one could still conclude that delayed gratification causes good life outcomes.

It wouldn't be difficult to do a few twin studies which would give a better indication of exactly what the causal mechanism might be.

I'm always surprised that when we have correlations of this type (e.g. a parent's educational attainment influences the child's attainment; richer families' offspring are likely to have higher incomes themselves) we assume in public discourse that it must be something external about the economic station of the parents (i.e. money, access to tutoring, whatever) that explains the difference. In reality it could be external factors, or behavioural factors, or heritable factors - we cannot say without twin studies or something beyond just a correlational study.

The reason I think it matters is that when you assume there's this objective dichotomy between "rational" and "irrational," you miss important things.  Because "irrational" basically means "we have no idea what they're thinking," so there's no point in trying to figure it out. 

No, we most often know exactly what objectively irrational people are thinking. For example, with gamblers, they either cannot regulate their dopamine cravings (this is not even internally rational. Often my own actions are not internally rational. I just make bad choices which I recognise as being bad choices, and I regret them later on. Is it rational to just give in to impulses that you know at the time are bad?) or otherwise they get fooled by variable ratio reinforcement schedules because the probability heuristics their brains employ are misled by the pokies machine.

[Glenstache]

I think that people use fuzzy logic rather than mathematical logic. We are pattern recognizing creatures, so tend to apply that rubric to decisions that fold in information from multiple sources and try to make it match the patterns in our framework of understanding. The degree to which that process is rigorous and immune to confirmation bias, improper assumptions, incomplete information, and emotional desires is variable. People tend to try and do the best for themselves, which is sometimes what is considered the "rational actor", but that should not be confused with some sort of formal logic or strictly based on monetary concerns.

[Telecaster]

These guys use math: 

https://en.wikipedia.org/wiki/Renaissance_Technologies

[Laura33]

Deprecating the value of the marshmallow study is in vogue right now, because the modern data shows that the correlations shown in the original marshmallow study are reduced or eliminated once you control for family income or cognitive ability. But what can we conclude from this? Nothing.

The fact that family income has a bearing on delay gratification might mean that children growing up in richer environments have more faith in future outcomes and therefore tend to discount future rewards less. Or it might just mean that self-regulation is important in succeeding financially and that parents who do so either pass on genes or teach children in a way that replicates the parents' qualities. In the latter case, one could still conclude that delayed gratification causes good life outcomes.

It wouldn't be difficult to do a few twin studies which would give a better indication of exactly what the causal mechanism might be.

I'm always surprised that when we have correlations of this type (e.g. a parent's educational attainment influences the child's attainment; richer families' offspring are likely to have higher incomes themselves) we assume in public discourse that it must be something external about the economic station of the parents (i.e. money, access to tutoring, whatever) that explains the difference. In reality it could be external factors, or behavioural factors, or heritable factors - we cannot say without twin studies or something beyond just a correlational study.

The reason I think it matters is that when you assume there's this objective dichotomy between "rational" and "irrational," you miss important things.  Because "irrational" basically means "we have no idea what they're thinking," so there's no point in trying to figure it out. 

No, we most often know exactly what objectively irrational people are thinking. For example, with gamblers, they either cannot regulate their dopamine cravings (this is not even internally rational. Often my own actions are not internally rational. I just make bad choices which I recognise as being bad choices, and I regret them later on. Is it rational to just give in to impulses that you know at the time are bad?) or otherwise they get fooled by variable ratio reinforcement schedules because the probability heuristics their brains employ are misled by the pokies machine.

I think you missed my point entirely.  I don't know what the "right" takeaway from the marshmallow study is (and I likely implied that I was, which isn't accurate).  The point is that the folks who did the study assumed that they knew what the right answer was, without considering the perspective of the kids involved, and that they may very well have reached the wrong conclusion as a result.  You can't even design the right sociological studies to get objective data if you don't understand the mindset and experiences of the people you're studying.

There is also a difference between "bad decisions that you know at the time are bad" and "bad decisions that seem like good decisions when they are made."  I am talking about the latter, while you are talking about the former.  I feel particularly strongly about this, because our house fire made me very, very aware of how a stressful situation can lead to poor decisionmaking, even when you feel completely calm and in control.  I mean, I was standing barefoot in the street in March, watching my house burn, and a neighbor offered me shoes.  And I said no!  I remember thinking it through -- I even remember exactly what I was thinking, and that it seemed eminently logical at the time.  It wasn't until later than I looked back and thought "WTAF?!?!"  That was the scariest thing of all:  that I made several terrible decisions that were objectively irrational, and yet they felt entirely rational and logical at the time.  That is something completely different from, "man, I know I need to drop 20 lbs., but BACON. . . ."   

[FINate]

I think you missed my point entirely.  I don't know what the "right" takeaway from the marshmallow study is (and I likely implied that I was, which isn't accurate).  The point is that the folks who did the study assumed that they knew what the right answer was, without considering the perspective of the kids involved, and that they may very well have reached the wrong conclusion as a result.  You can't even design the right sociological studies to get objective data if you don't understand the mindset and experiences of the people you're studying.

In fairness to the study authors, I'm going to ask for a source on claims they came to the wrong conclusions. My understanding (which I could be wrong about) is that their main finding was around methods kids used to suppress short term frustration from delaying gratification. Then long term follow up found correlation (not causation) between delayed gratification and success later in life.

Of course, people with various agendas jumped to conclusions and made causal claims to support their point of view, but this isn't something the authors should be blamed for.