Economics Questions

Re: Efficient Market Hypothesis

Clayton — Tue, 12 Oct 2010 22:32:26 GMT

I must admit I still find it hard to intellectually grasp what it means to know that a security, for instance, has radically departed from a fundamental value and will eventually return to that value; such knowledge would (if we are to believe basic economic theory) provide a strong incentive for arbitrage.

So, it would be impossible for a fractional-reserve bank to profitably engage in credit-inflation while simultaneously shorting the market into which it is lending? I don't see anything logically impossible about this, or even difficult to comprehend.

Clayton -

Re: Efficient Market Hypothesis

Clayton — Tue, 12 Oct 2010 22:27:16 GMT

The trouble I have with EMH is that any time I buy something and resell it for more than I purchased it, I have "beaten the market." If it were not possible to beat the market, then profitable business (or profitable-anything-else for that matter) would not be possible. Entrepreneurs are actually identifying profit opportunities (disequilibria, if you like) and exploiting them to make money, thereby, "beating the market."

Or, perhaps I'm just confused.

Clayton -

Re: Efficient Market Hypothesis

Lagrange multiplier — Tue, 12 Oct 2010 22:22:01 GMT

Chris Pacia:
I'm having an interesting discussion with my professor on EMH and I'm trying to show him the failure of EMH to explain bubbles. He's taking the position that the price of the assets at the height of the bubble took into account all known information. When new information was known the market adjusted. I've mentioned low interest rates, but have stopped short of fully explaining ABCT.

I definitely believe in the weak version of the efficient-market hypothesis. Failure to explain "bubbles" is not necessarily a weakness of the hypothesis if the term "bubble" itself is incoherent. Quoting Eugene Fama, "I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning."

I must admit I still find it hard to intellectually grasp what it means to know that a security, for instance, has radically departed from a fundamental value and will eventually return to that value; such knowledge would (if we are to believe basic economic theory) provide a strong incentive for arbitrage.

Re: Efficient Market Hypothesis

Smiling Dave — Tue, 12 Oct 2010 09:54:13 GMT

Jonathan Mariano:

Rational expectations suggests the standard economic assumption that people behave in ways that maximize their utility (their enjoyment of life) or profits. From the Austrian perspective, rational just means purposeful, not necessarily financial maximization. Furthermore, value is subjective. This would runs counter to rational expectations.

There's one more thing. It's not "people behave in ways that maximize their utility", but rather "people behave in ways that they think will maximize their utility".

Big difference. Cause there are a lot of mistaken people out there.

Re: Efficient Market Hypothesis

Jonathan Mariano — Tue, 12 Oct 2010 09:27:20 GMT

The EMH is merely the application of Rational Expectations to financial markets.

If rational expectations is disproven, would that imply that EMH (weak or strong) is disproven as well?

Rational expectations suggests the standard economic assumption that people behave in ways that maximize their utility (their enjoyment of life) or profits. From the Austrian perspective, rational just means purposeful, not necessarily financial maximization. Furthermore, value is subjective. This would runs counter to rational expectations.

Re: Efficient Market Hypothesis

Esuric — Tue, 12 Oct 2010 08:35:00 GMT

The EMH wikipedia entry suggests that EMH is related to financial markets, but not necessarily markets.

The EMH is merely the application of Rational Expectations to financial markets. It basically says that markets price better than individuals (because of arbitrage). If individual's continuously "beat the market," in the average, then it would mean that individuals are better at pricing assets than the market (beating the market should be a random occurrence). In other words, it would mean that markets are inefficient. I believe that this theory only holds (the weak version) when there isn't continuous government intrusion within markets, especially within money and capital markets. The strong version of the EMH is demonstrably false and it makes no sense (prices represent "intrinsic" values).

Re: Efficient Market Hypothesis

Jonathan Mariano — Tue, 12 Oct 2010 07:57:00 GMT

The EMH wikipedia entry suggests that EMH is related to financial markets, but not necessarily markets.

Re: Efficient Market Hypothesis

Tue, 12 Oct 2010 04:22:50 GMT

2. I don't see why govt policy distorting fundamentals should change the argument. The existence of the govt is not a secret. Everyone has that info.

Everyone does not have the same info when dealing with government. If they did then everyone would have avoided investing in the housing market knowing that Fed policy was just creating an unsustainable boom. How can you possibly make that claim? Same thing with gold. If everyone knows impact of the fed's policies then people would have invested in gold years ago.

Re: Efficient Market Hypothesis

Smiling Dave — Tue, 12 Oct 2010 04:02:02 GMT

Chris Pacia:

Smiling Dave:

I don't see any basis for such an assumption. We may all have the same information, but some people know what to do with it.

Couldn't one make the claim that the ones who know what to do with it will drive the ones who don't out of the market?

And how long will that take? Remembering P.T. Barnum's maxim, there are always new suckers, so it will never happen.

Wouldn't that mean that the only people remaining would be the ones who know what to do with the information? If that is the case how can one of these individuals beat the rest on average?

So the EMH is only applicable if it assumes smart players? All equally smart? All equally smart and equally informed about all the many thousands of stocks? What connection does this have to reality? So there is no Warren Buffet? He is just a product of dumb luck? It really boggles the mind to see this taken seriously.

Your gold example isn't a very good one because government policy distorts market fundamentals. We are assuming pure laissez faire here.

1. So the EMH has no application in the world as we live it? They are all speaking about a fantasy world where there is no govt?

2. I don't see why govt policy distorting fundamentals should change the argument. The existence of the govt is not a secret. Everyone has that info. In fact you seem to be making my case stronger, by saying that the guys who said gold would go up could not have known what they were talking about, cause the govt distorted things. So you seem to be saying that of course it was dumb luck, and their well thought out reasons, publicly displayed, are just the typings of monkeys. I don't buy it.

Re: Efficient Market Hypothesis

Tue, 12 Oct 2010 03:35:38 GMT

Smiling Dave:

I don't see any basis for such an assumption. We may all have the same information, but some people know what to do with it.

Couldn't one make the claim that the ones who know what to do with it will drive the ones who don't out of the market? Wouldn't that mean that the only people remaining would be the ones who know what to do with the information? If that is the case how can one of these individuals beat the rest on average?

Your gold example isn't a very good one because government policy distorts market fundamentals. We are assuming pure laissez faire here.

Re: Efficient Market Hypothesis

Smiling Dave — Tue, 12 Oct 2010 02:37:43 GMT

It doesn't assume that everyone acts the same. In fact it's exactly the opposite. Some people will price the stock below the market average and sell, others will prices it above the average and buy. This is how market prices are formed. But it suggests that half will be right and earn an above average return, and half will be wrong and earn a below average return.

1. What is the basis for assuming that half will be right and half will be wrong?

2. The OP seems to be saying that no one can beat the market, because the law of averages will make sure he is wrong half the time.

I don't see any basis for such an assumption. We may all have the same information, but some people know what to do with it.

As a simple example, some people have been saying for years that gold will go up up , up, and giving their reasons. Does the EMH say they were just lucky? That they may think they know what they are talking about, but they really don't?

Re: Efficient Market Hypothesis

Tue, 12 Oct 2010 02:17:29 GMT

Smiling Dave:

1. So there is no such thing as insider trading?

2. So all people are equally intelligent? And they all think the same way? Why is there ever any disagreement about anything at all, seeing as we all have the same information? Why do debates not end with one side conceding every single time?

3. Bottom line, there are two assumptions that I don't see the evidence for. That everyone has identical information, and makes the same use of it.

1. This would imply the "strong form" of the hypothesis. Obviously insider information takes time to filter through to the entire market. Which is why I would reject the strong form.

2. It doesn't assume that everyone acts the same. In fact it's exactly the opposite. Some people will price the stock below the market average and sell, others will prices it above the average and buy. This is how market prices are formed. But it suggests that half will be right and earn an above average return, and half will be wrong and earn a below average return.

3. Again this implies strong form. I think the real question is whether it is weak and semi-strong form.

Re: Efficient Market Hypothesis

NewLiberty — Tue, 12 Oct 2010 02:09:10 GMT

markets price in all available information that people act on, not all available information. That is the crucial distinction.

Re: Efficient Market Hypothesis

Smiling Dave — Tue, 12 Oct 2010 02:06:09 GMT

1. So there is no such thing as insider trading?

2. So all people are equally intelligent? And they all think the same way? Why is there ever any disagreement about anything at all, seeing as we all have the same information? Why do debates not end with one side conceding every single time?

3. Bottom line, there are two assumptions that I don't see the evidence for. That everyone has identical information, and makes the same use of it.

Re: Efficient Market Hypothesis

Tue, 12 Oct 2010 01:53:35 GMT

Smiling Dave:

If you can kindly explain why everyone would beat the market half the time, then I might buy into it. As is, it sounds pretty silly.

Of course we can test it by going to ESPN.com and checking if their experts predicted game outcomes about 50% of the time. If they didn't that would kill the EMH, no? If they did, it would need further testing, and even more, a solid reasoned explanation.

The theory goes that markets (particularly stock markets) price in all available information. This means that you don't have any more information to base your investment decisions on than the millions of other people pouring over the data. The implication is that for a given level of risk, in the long run you will be unable to earn a higher return than the market average. So if market has a beta of 1.0 and a return of 8%, you may earn either above 8% or less than 8% on a particular stock with similar risk, but in the long it will average out to 8%. Again, if you don't have any different information than the millions of other investors, how can you consistently earn a higher return than them?