Efficient Markets Survey

Thanks Bchad. This is precisely what I was aiming for. Being a young guy with limited asset management experience, I am curious to hear insight from the trenches versus what academics and book writers say. While academics and book writers are smart people, my hunch tells me that if they really did ‘get it’ they would be killing it in the stock market and not writing a book or doing research in the public sector.

A test of efficiency using CAPM is only as good as the model itself… It’s almost impossible to prove whether or not the market is efficient, because then it comes down to simply if the model is valid It’s obvious that CAPM has it’s limitations (alot of unrealistic assumptions) …Holding “all risky assets” is not possible…which beta is to be used…?? How do you determind BETA i.e. beta changes in response to weekly data, monthly data, 5 year period vs 2 year period, NYSE vs TSX vs FTSE et cetera… Technical analysis has been shown to be of NO USE (based on empirical evidence)…but it’s still widely used…and aside from academic research, I believe it’s atleast worthwhile to consider in an analysis! Feel free to disagree completely in any of my opinions.

spierce Wrote: ------------------------------------------------------- > maratikus Wrote: > -------------------------------------------------- > ----- > > Markets are nearly efficient. Inefficiencies > do > > exist but persistent inefficiencies are very > > difficult to find. > > If the markets were efficient, or even “nearly” > efficient, the tech bubble and mortgage bubble > would never have happened. The problems were so > endemic and thoroughly distributed that any single > firm exceeding risk tolerances of the market would > have been punished and nobody else would have > endeavored to do the same. This is what the > “market” does, punish those who operate outside > the bounds of what is expected. > > Obviously nearly every single financial firm > operated well outside of its expected risk > metrics. > > I would actually put forward that the markets are > near perfectly inefficient. Humans, as a group > (aka “market”), are obviously very bad at > realizing the truth. > > This continues. Look at Greece. There are criticisms of market efficiency. For example, here: http://www.ritholtz.com/blog/2009/08/six-impossible-things-before-breakfast/ However, if you tell me that markets are ‘near perfectly inefficient’, I’d like to see your track record which should reflect how you have captured market inefficiencies. Many smart people lost a lot of money because they thought markets were wrong.

nothing can be partially efficient or almost efficient or nearly efficient. the definition of efficient in the way that we are using it according to MW is: “productive without waste” you can’t be wasteful AT ALL and still be “efficient”. the market is inefficient. also, even after considering all knowledge and data gained from the past, that data is used to estimate the future, which is completely uncertain. we apply probabilties to the possible occurence of certain events, yet our approximation of these events is completely subjective. the only thing we can estimate is a future which resembles the past. thus, like someone has already toted on, because humans are inefficient, so too is the market. humans maintain temporary “efficiency” through arbitrage and pricing theory until their means or fears no longer allow them to. the problem is that in this case “efficiency” means buying/selling at the wrong time and is actually inefficient and completely wasteful. taking all of the above into consideration: markets are inefficient in the very short-term due to random walk markets are inefficient in the short-term due to the battle between TA, FA, and whatever arb trading machines are programmed to do at any given moment, likely a combo of TA and FA markets are inefficient in the intermediate- and long-term due to markets’ tendency to succomb to investor confidence/behaviour and the fact that the distant future is forecasted to look like the recent past.

i think the word we may be looking for is equilibrium. all of our predictions are derived from periods of time when most of our markets are near a previously measured ‘equilibrium’. when these markets are near equilibrium as measured previously, we have reasonable confidence that we can predict how certain participants (stocks, bonds, etc) will perform. even still, there are tails and we can get crushed, and sometimes a “tail” can turn into a new paradigm.

MattLikesAnalysis Wrote: ------------------------------------------------------- > the definition of efficient in the way that we are > using it according to MW is: “productive without > waste” > Is anything in the universe “efficient” under this definition?

higgmond Wrote: ------------------------------------------------------- > MattLikesAnalysis Wrote: > -------------------------------------------------- > ----- > > the definition of efficient in the way that we > are > > using it according to MW is: “productive > without > > waste” > > > > Is anything in the universe “efficient” under this > definition? yes. every single thing that is not man-made. all natural processes have “waste” but this “waste” is useful in another process and is not actually “waste”.

MattLikesAnalysis Wrote: > markets are inefficient in the very short-term due > to random walk why is random walk an indication of inefficiency?

maratikus Wrote: ------------------------------------------------------- > MattLikesAnalysis Wrote: > > markets are inefficient in the very short-term > due > > to random walk > > why is random walk an indication of inefficiency? this is the only thing i’m not 100% sure on to be honest, but its my understanding that random walk is only accepted as a result of the market’s “efficiency” in the LT. But when looking at the very short-term (intraday), random walk leads to unpredictability which is the hallmark of inefficiency (i.e. an efficient process is predictable, see: biological and chemical processes, but an inefficient process is completely unpredictable). that is the whole reason for debate. efficiency = the validity of FA and TA but inefficiency = invalidity

So the “waste” created when a monkey rubs one out is somehow beneficial to the universe because it serves some other purpose, but the “waste” in financial markets is just waste and therefore markets are inefficient? I think I’ll call this the “Monkey Spank Theory of Market Inefficiency”. I can already smell the Nobel (to be technically correct, The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel).

higgmond Wrote: ------------------------------------------------------- > So the “waste” created when a monkey rubs one out > is somehow beneficial to the universe because it > serves some other purpose, but the “waste” in > financial markets is just waste and therefore > markets are inefficient? I think I’ll call this > the “Monkey Spank Theory of Market Inefficiency”. > I can already smell the Nobel (to be technically > correct, The Sveriges Riksbank Prize in Economic > Sciences in Memory of Alfred Nobel). the waste in markets is inappopriately allocated capital, in terms of both financial and human capital, so that it slows or reduces overall growth. the purpose of financial markets is to maintain and generate wealth and anything that TAKES from that should be considered waste. the monkey goo is eaten by parasites and yes, does contribute to another system. even if the monkey keeps it inside, the goo dies and a natural process occurs within that monkey’s body. the comparison was obviously lacking thought. ever heard of AMH? its in the cirriculum. what i’m saying is not that obsurd, according to 100% of those who have considered theories alternative to the EMH.

Things can certainly be “nearly efficient,” as long as we have some sense of what it means to be “far from efficient.” If 99% of the energy in a system is converted to useful work, then we can justifiably say that it is “nearly efficient,” provided that we understand that it would not be surprising to get substantially less than 99% most of the time. Similarly, the efficient markets hypothesis has a specific meaning about how information is reflected in prices. Perfectly efficient is certainly an unrealistic standard, but given that one might expect information to be reflected very slowly in prices (perhaps because it takes time for lots of people to get informed and make the relevant decisions), one can say that markets are nearly efficient if prices adapt to new information substantially faster than one might otherwise expect. Just because I can’t identify exactly when twilight becomes night doesn’t mean that there isn’t twilight and there isn’t night.

haha. bchad, whenever i see that you respond to one of my comments, i get a lump in my stomach b/c you’re the only one of the forum who consistently posts well-thought out responses, often to the demise of my radical views (radical meaning awesome)… if efficient is a perfect state, and we know that the market can never be truly efficient, how can we ever say its near efficient? how can we ever be near something that is unachievable? i bet that in 1900, people were claiming that we were near efficient. “near efficient” disregards human progress which is sure to occur in the near future. there’s one that works. near future. the future is real and achievable and expected, so we can be near it. they didn’t know they were “far from efficient” 100 years ago and we don’t know that we are far from efficient today. if the process of “achieving efficiency” is a ongoing process that has occured over time, how can we claim we are nearly efficient today, when it is expected that we will be more efficient tomorrow? this line of reasoning completely negates your “as long as we have some sense of what it means to be far from efficient” argument (i.e. we are further from efficient today than we are tomorrow). your argument would then hold true that the day of achieving a nearly efficient market was day 2 of capital markets, after we saw the havoc of and learned our lessons from day 1. hindsight bias?

MattLikesAnalysis Wrote: ------------------------------------------------------- > higgmond Wrote: > -------------------------------------------------- > ----- > > So the “waste” created when a monkey rubs one > out > > is somehow beneficial to the universe because > it > > serves some other purpose, but the “waste” in > > financial markets is just waste and therefore > > markets are inefficient? I think I’ll call > this > > the “Monkey Spank Theory of Market > Inefficiency”. > > I can already smell the Nobel (to be > technically > > correct, The Sveriges Riksbank Prize in > Economic > > Sciences in Memory of Alfred Nobel). > > > the waste in markets is inappopriately allocated > capital, in terms of both financial and human > capital, so that it slows or reduces overall > growth. the purpose of financial markets is to > maintain and generate wealth and anything that > TAKES from that should be considered waste. > > the monkey goo is eaten by parasites and yes, does > contribute to another system. even if the monkey > keeps it inside, the goo dies and a natural > process occurs within that monkey’s body. > > the comparison was obviously lacking thought. ever > heard of AMH? its in the cirriculum. what i’m > saying is not that obsurd, according to 100% of > those who have considered theories alternative to > the EMH. Lo’s AMH is interesting and certainly not without merit, but is a theory. He could be right, he could be wrong. It is interesting that you cite AMH though, given that is partially based on the application natural selection and Lo notes that natural selection (a very natural process) is not always efficient. To be honest, I don’t necessarily disagree that markets are not efficient. The persistent use of absolutes suggests a closed mind to me though and undermines the strengh of what could be very valid arguments.

you still don’t get it. natural selection is still a man-made theory. its not a biological process. anything man-made is inefficient and can never be described as nearly efficient due to the fact that the very goal of human progress is the pursuit of efficiency and that nearly efficient is impossible without disregarding human progress. also, i don’t think Lo i right either, i merely used him to point out to you or others who may be new to all this that there is more than just EMH floating around. every theory based on a human system will be disregarded or further improved one day so no theory is correct. it is the essence of human progress. the only things we can hold true is how chemicals react with eachother and how our digestive system works.

the day that we map out every single individual’s financial situation along with all of the current and to be invented financial instruments along with every innovation in future which will have an effect on markets, we will be able to PREDICT what market participants will do. even then, when every piece of data has been collected, all 6 billion individuals’ free will will interrupt any assumption that can be made. unless we start breeding psychics, and in turn we surrender our freedom of thought and behaviour, we will experience inefficient markets. its a question of philosophy, not science.

MattLikesAnalysis, I don’t think we use the same definition of efficiency. Efficient Market Hypothesis assumes informational efficiency. “That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information publicly available at the time the investment is made.” http://en.wikipedia.org/wiki/Efficient-market_hypothesis You talk about economic efficiency. http://en.wikipedia.org/wiki/Economic_efficiency

maratikus Wrote: ------------------------------------------------------- > MattLikesAnalysis, I don’t think we use the same > definition of efficiency. > > Efficient Market Hypothesis assumes informational > efficiency. “That is, one cannot consistently > achieve returns in excess of average market > returns on a risk-adjusted basis, given the > information publicly available at the time the > investment is made.” > http://en.wikipedia.org/wiki/Efficient-market_hypo > thesis > > You talk about economic efficiency. > http://en.wikipedia.org/wiki/Economic_efficiency not entirely. inefficient markets as defined by the EMH leads a misallocation of capital which leads to market failure which is results in economic inefficiency.

MattLikesAnalysis Wrote: > not entirely. inefficient markets as defined by > the EMH leads a misallocation of capital which > leads to market failure which is results in > economic inefficiency. Do you mind elaborating on that? Let’s start with the first statement. 1) inefficient markets as defined by EMH means that it’s possible to consistently outperform market. How does that lead to misallocation of capital?

MattLikesAnalysis Wrote: ------------------------------------------------------- > > not entirely. inefficient markets as defined by > the EMH leads a misallocation of capital which > leads to market failure which is results in > economic inefficiency. The concept of a misallocation of capital suggests to me that there has to be a correct allocation of capital. Who or what determines the correct allocation of capital? Is there even such a thing?