Monday, June 8, 2009

The Idiocy of the Efficient Market Hypothesis

In the NY Times today is a great article about challenges to the Efficient Market Hypothesis (EMH), a theory of academic financial research about how the stock market operates. EMH, in this version, says that all information that is relevant to the price of a stock is always available to all parties. Therefore, the price of a stock always reflects a judgment about its worth based on this totality of information. Therefore, the markets are efficient, because the price of a stock always reflects a perfect understanding of its current situation.

I don't know why anyone takes this idea seriously, because I think it's complete nonsense. Hogwash. Garbarge. Worthless trash.

The first problem is this idea that all information about a company is always available to every investor. That's not physically possible. There is vastly more information about a company, available in a veritable cornucopia of formats, than one human being could possibly synthesize. The information that is available in an SEC report is the tiniest shred of a sliver of the totality of information about that company. And that's true of just about any company.

Even more important than the information about a company that the company can provide is the information that it cannot provide, particularly about two key groups: its competitors, and its customers. Few companies really know what their competitors are up to, until the information becomes public. Same thing with their customers.

But what really bugs me about EMH is this idea that decisions about investments are made based on information that the investor has access to. This is just an incredibly stupid idea. No one makes investment decisions based strictly on the information they have at hand. They make investment decisions based on what that information tells them about the future.

Every investment decision is a decision about the future. Will this stock go up or down? That will be determined in the future. The events that determine whether a stock goes up or down will take place in the future. It is not physically possible to have access to that information.

Every investment decision is based on a prediction, not knowledge. Investors use their knowledge to try to refine their predictions, but they are still estimates and guesses.

The last contradiction that exposes the inadequacy of EMH is the simple fact of the stock market's existence. Every time a security is traded, there are two sides to the transaction - a buyer, and a seller. Each has the exact opposite opinion of what will happen in the future. The buyer thinks the stock will go up. The seller thinks the stock will go down. That's a shade simplistic; the seller may think that the stock is going to go up, just not as much as she would like. But the point is that each has a different idea about what is going to happen to the particular security. If there were not that difference of opinion, there would not be a transaction. If information about a security were truly complete and perfect, we could not have a stock market, because everyone would agree about the value of the security, and everyone would be on the same side of the transaction. But we do have markets for financial products, because we do have differences of opinion about what will happen in the future.

I understand that there are different versions of EMH, and I may very well be attacking a straw man. But this has been bothering me for years. I heard about EMH a long time ago, and haven't really had a chance to vent about this until now. So I feel better now.

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