Why the efficient markets hypothesis caught on

By Felix Salmon
August 11, 2009
long answer (HarperBusiness, 400 pages, $27.99), and then there's the short answer, courtesy of Emanuel Derman:

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Why did the efficient markets hypothesis catch on as virulently as it did? There’s the long answer (HarperBusiness, 400 pages, $27.99), and then there’s the short answer, courtesy of Emanuel Derman:

The EMH does recognize one true thing: that it’s #$&^ing difficult or well-nigh impossible to systematically predict what’s going to happen. The EMH was a kind of jiu-jitsu response on the part of economists to turn weakness into strength. “I can’t figure out how things work, so I’ll make that a principle.”

See? Economists are scientists, after all. That which they can’t explain, they turn into an axiom.


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Dear spouting off kid, you just opened up a can of worms..

-thou shall not attempt to qauntify human nature

Posted by dvictr | Report as abusive

There is nothing particularly wrong with the EMH, there is a great deal wrong with most poeple’s understanding of it.

Here is a good medium-length explanation.

Posted by Shnaps | Report as abusive

Agreed with Shnaps. The EMH is so axiomatic as to be trivial. When large scale deviations are found it’s amazing that the conclusion is automatically that the EMH is wrong, rather than that we do not live in a world of efficient markets. They’re close, and they tend toward efficiency, but when information is available its possible that either a) not everybody notices it, b) not everybody interprets it the same way or c) people notice it but collectively assume that everybody else must be right in not reacting to it, so they don’t react either.

Remember the short seller who called Enron on its antics was using information plainly available. 2008 was not the first failure of the EMH to apply to real life.

Posted by Mike Nute | Report as abusive

One big problem with the EMH is the “efficient” part. Not, that is, the behavior it describes, but the WORD. Most people who hear it – and quite possibly most people who use it – think it means the same thing as when we say a refrigerator is energy-efficient. So it must be good, right?

Posted by Ken | Report as abusive

Not sure what the point of this little blurp was, Mr. Salmon. Are you challenging equity valuations? Are you concerned that the economy is ‘run by’ or ‘based on’ models that market professionals use to help form investment strategies?

The problem with markets thes days is the same problem with government and the public-at-large… lack of educated decision making. People don’t take the time to do their ‘homework’ from info that is openly available. Instead they are only too happy to let someone else make the decisions or do the due diligence for them, not expecting that those people may be taking advantage of them. Same with government passing laws where the legislation was never read by a single soul that was voting on it.

I’ll close by saying that I believe firmly in the old saying of “when all your neighbours are in the market, you should be getting out.” There is a very real reason for this statement: the public-at-large is not willing to understand the market and acts irrationally as a result. That’s when all models go out the window!

Posted by the Shah | Report as abusive

Or you could hear the man himself (Eugene Fama) describe what the EMH means in this video posted today on his blog:

http://www.dimensional.com/famafrench/20 09/08/fama-on-market-efficiency-in-a-vol atile-market.html

Posted by Mr Denmore | Report as abusive

well, there was an economist walking along with a companion, and the companion saw a bit of information on the sidewalk. “careful, that must be an illusion,” said the economist, “all the information is already incorporated in prices.”

Posted by bdbd | Report as abusive

I think the EMH concept gained ground because when it was applied to security pricing, it worked. And it worked quite a while so it pulled in adherents, client money and wealth to those who understood how to use EMH.

Then it stopped working. Lost money, lost adherents. Move on.

Next derivatives. They worked well too (a few early bumps like Merrill and Orange County, to name just one.) Gained adherents, brought in clients, made money.

Until it stopped working. Lost money, lost adherents. Move on.

What’s next? Commodity futures trading. Has anyone got a derivative for this, based on EMH. Boy, that’s going to be one bustup.

I’m not a particular proponent of the EMH, but what’s not effecient about a 50 per cent fall of equity markets in the rarified atmosphere of the largest debt bubble in history?

Just because 99 percent or more of the financial world cannot see the wood for the trees doesn’t make the market inefficent.

The US and other debtor nations have had their pumped up asset bases reduced by the markets. Apply GAAP measures to these countries and what right minded equity analyst would punt these perennial losers, the base upon which the vast majority of the companies feed from?

I would argue that’s the closest indication of efficiency seen since the tech bubble burst, and another down leg to around 4000 on the Dow will “efficiently” refute the world-saving stimulus hypothesis and the supposedly “critical” function of financial services in the global economy.

Gareth C

Posted by Gareth C | Report as abusive

This was an incredibly stupid comment. The EMH caught on because it failed to be rejected in numerous empirical tests. This was certainly true in all early tests. Famous “rejections” such as Shiller’s excess volatility tests turn out not to be rejections at all. Marsh and Merton showed that if firms smooth dividends the variance bound is violated in theory so that Shiller’s test is SUPPORT for the EMH. But of course this would required reading or knowing some economics.
While there is still lots of discussion, the main reason why economists cling to the EMH is that there is no competing hypothesis that does better. No theory is replaced without a better alternative. What is out there that explains more?
I guess I should not expect more from someone who thinks Taleb is insightful.

“it’s #$&^ing difficult or well-nigh impossible to systematically predict what’s going to happen. You may think you know you’re in a bubble, but you still can’t tell whether things are going up or down the next day.”

I hear this a lot, but it’s very misleading. You may not be able to forecast well what will happen tomorrow, but 10 years from now, 20, 30+, there, there’s been shown to be a great deal of qualitative, trend, forecastability, predictability, of excess or deficit risk-adjusted returns. For example, it’s been shown strongly that, contrary to the EMH, high P/E’s lead to low risk-adjusted returns over the long run, and vice-versa. For a nice article explaining this, accessible to laypeople, see ‘Recent Stock Declines: Panic or the Purge of “Irrational Exuberance”?’, in the Economists’ Voice, at: http://www.bepress.com/ev/vol5/iss7/art6  / .

There is not complete unpredictability in the market just because you cannot tell well if a bubble will burst tomorrow. That just means you don’t have complete, or near complete, predictability. But the complete unpredictability of the EMH would mean that in a bubble (defined by something like very high P/E ratios), there would still be an exactly 50-50 chance of an above average risk-adjusted return over the long run, and the research has shown overwhelmingly that the probability is much higher.

Saying there is not complete unpredictability in the market, other than on average you will get the risk-adjusted return, as EMH essentially does, because you cannot tell well if a bubble will burst tomorrow, is like saying the weather is completely unpredictable because we can’t tell for sure if it will stop raining in the next 10 minutes. There’s still a ton we can tell; there’s still a great deal of predictability. It’s not like we cannot tell if the odds of rain tomorrow are any higher or lower than the average percentage of times it rains per day. By looking at cloud patterns, wind patterns, etc. we can tell, in a very non-EMH way, that the odds of rain are much higher, or much lower, than that. There’s a great deal of predictability, especially qualitative predictability, even if there is not perfect predictability.

I also recommend on this two books accessible to laypeople: “Stocks for the Long Run”, 4th edition, by Wharton finance professor Jeremy Siegel, and “The New Finance”, 4th edition, by former University of California, Irvine, finance professor, and now CEO of Haugen Custom Financial Systems, Robert Haugen.

Is it truly necessary to continue the continuous stream of by now gratuitous references to Mr. Fox’s book? Perhaps Mr. Salmon is also writing his ‘big book,’ and is hoping that Mr. Fox will respond in kind?

Posted by Philip Rothman | Report as abusive

I should add that by and large the skilled academics who criticize the efficient market hypotheses, criticize it for it’s unrealistic extremeness. They’re not saying that the market is completely inefficient crazy, they’re just saying it’s far from perfectly efficient (or even perfectly non-strong form efficient), and prone to bouts of very significant inefficiency.

A common reply is that if prices of assets like stocks are too low, the expert savvy investors, even if they are only a small minority of the population, will be able to profit by buying them, and will keep buying them and profiting until they are no longer underpriced (which is assumed to happen in the EMH extremely quickly).

There are many serious problems with this, but a key one which I stated in a 2006 letter in the Economists’ Voice (at: http://www.bepress.com/ev/vol3/iss8/art3  /) is:

One reason…which I have not seen yet in the literature, at least explicitly, is that a smart rational investor is limited in how much of a mispriced stock he will purchase or sell by how undiversified his portfolio will become. For example, suppose IBM is currently selling for $100, but its efficient, or rational informed, price is $110. It must be remembered that the rational informed price is what the stock is worth to the investor when added in the appropriate proportion to his properly diversified portfolio of other assets. Such a savvy investor will purchase more IBM as it only costs $100, but as soon as he purchases more IBM, IBM becomes worth less to him per share, because it becomes increasingly risky to put so much of his money in the IBM basket. By the time this investor has purchased enough IBM that it constitutes 20 percent of his portfolio, the stock may have become so risky that it’s worth less than $100 to him for an additional share. At that point he may have only purchased enough IBM stock to push the price to $100.02, far short of its efficient market price of $110. Thus, if the rational and informed investors do not hold or control enough—a large enough proportion of the wealth invested in the market—they may not be able to come close to pushing prices to the efficient level.

Christopher Carol and Tod Allen at John Hopkins point out that people cannot live long enough to navigate an open market using either optimal learning or trial and error.

Put that in your pipe while considering the enormous experiment we’ve hoisted.

A quote from their .pdf at http://www.econ.jhu.edu/people/CCarroll/ indiv_learning_about_c_nber.pdf, “pure trial-and-error learning requires an enormous amount of experience to allow consumers to distinguish good rules from bad ones – far more experience than any one consumer would have over the course of a single lifetime.”