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  1. #1
    in-game Gamine's Avatar
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    Default Do you believe in the Efficient Market Theory?

    I have my own raging bias on this one. I am curious to find out what your general consensus is. Here is a very current article printed in The Economist.

    Economist - Proving/Disproving EFM

    The grand illusion
    Mar 5th 2009
    From The Economist print edition

    How efficient-market theory has been proved both wrong and right

    Illustration by S. Kambayashi

    THE past ten years have dealt a series of blows to efficient-market theory, the idea that asset prices accurately reflect all available information. In the late 1990s dotcom companies with no profits and barely any earnings were valued in billions of dollars; and in 2006 investors massively underestimated the risks in bundling together portfolios of American subprime mortgages.

    There is now widespread acceptance that investors can behave irrationally, creating very large anomalies. Take the momentum effect, the practice of buying the stockmarket’s best performers over the previous time period. A study by the London Business School found that, since 1900, buying British stocks with the best momentum would have turned £1 into £1.95m (before costs and tax) by the end of last year; the same sum invested in the worst performers would have grown to just £31. In efficient markets, such an anomaly should be arbitraged away.

    Belief in efficient-market theory made the authorities reluctant to restrain either the dotcom or the housing and credit bubbles. Perversely, the result has been much greater state interference in the markets than was dreamed of ten years ago, with commercial banks being nationalised or subsidised, and central banks acting as a buyer of last resort for financial assets.

    But it is important not to throw out all the insights of efficient-market enthusiasts. Although it is theoretically possible to make money by outperforming the markets, it is extremely difficult in practice. That ought to have made investors suspicious of the smoothness of the returns of Bernard Madoff, who has been accused of a vast fraud. His strategy, as advertised, might have produced less volatile returns than the index, but the absence of negative months suggested almost perfect market timing.

    Some fund managers have beaten the markets over long periods. The problem is to identify them in advance. Picking them after they have outperformed may be too late, as those who backed Legg Mason’s Bill Miller have recently discovered. Why is this? Fund managers are human too and subject to behavioural biases. In addition, the larger their funds become (as their reputation spreads), the more difficult it is to outperform.

    The temptation has also been to assume that fees are positively correlated with performance—that if mutual fund managers charging 1.5% are good, hedge-fund managers charging 2% (and 20% of performance) are even better. Because investors cannot beat the market in aggregate, all this means is that money is transferred from investors to fund managers. Even David Swensen, the man who led the drive into alternative assets at Yale University, thinks most investors should rely on low-cost index-tracking funds.

    But perhaps the area where the efficient-market hypothesis should have had greater weight is at banks. Many lament the demise of old-style banking, the “three-six-three” model where bankers borrowed money at 3%, lent it at 6% and were on the golf course at 3pm. That model broke down because markets were fairly efficient; the margins on lending to corporations became too low.

    So banks were attracted to the higher-margin business of investment banking. Commercial banks could use their capital to back up their advisory operations and outmuscle old-style investment banks. The latter duly abandoned the partnership structure and raised money on the stockmarket, or were bought by commercial banks. The same logic required new trading desks to handle the banks’ positions, and those desks quickly became profit centres of their own.

    But how were those trading desks making money? Perhaps they were exploiting information gathered by the rest of the group, a tactic that, if not illegal, put them in conflict with their clients. Or they were taking advantage of an artificially low cost of capital. With commercial banks, that cost was low because of the implicit public subsidy provided by deposit guarantees. Without such guarantees, savers would have wanted higher interest rates from banks with trading arms to reflect the risk of a market-related loss. In the good years, when they randomly beat the market, the traders earned bonuses. In the bad years, the taxpayers have picked up the bill.

    And that raises a fundamental question. If regulators thought markets were too efficient to interfere with, how come they allowed banks to get involved in an activity which, after bonuses, was a game they collectively could not win?


    Questions:

    1) We continually attribute market successes to "market timing", though the percentage of trained investors who can with some regularity find growing trends in the market to invest in is very very very small. With the lack of connection between this ideal and the statistical proof of its existance, why do you think this myth is still propagated?

    2) Do you support the EFM? For what reasons? If not, why?

    3) If you were to alter the EFM to be more accurate for real investing, how would you change it?

    4) Do you perceive the market as rational?
    "Beware Those Who Are ALWAYS READING BOOKS" - Bukowski

  2. #2
    Senior Member Rangler's Avatar
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    Are capital markets efficient or not is a bad question, how efficient they are is a good question. There's no question that markets are efficient to a degree. However, I believe they are less efficient than the Efficient Market Theory would have you believe.

    Underlying the Efficient Market Theory is Decision Theory, where people perfectly update their exceptions based on new information. The main critique of this comes from psychology, where people are shown to under and overreact for various reasons: overconfidence is their analytical ability, assigning more value to new information that reinforces their old expectations, ect...

    Also, perfectly efficient markets do not have bubbles like we have seen for the past decade. Not one major investor believes in Efficient Market Theory, because if it were true, there would be no way to consistently beat the market rate of return.

    I think that this recession has also decreased the efficiency of the capital markets because of fear due to uncertainty. The markets are really irrational at the moment because no one has any idea where the bottom of the recession is.

    As an accounting student, I can tell you that the trend in accounting theory and practice has been to move away from Efficient Market Theory, as demonstrated by valuing securities at market values. This puts unrealized gains and losses on the income statement. Ironically, this is why banks are failing at the moment.
    Last edited by Rangler; 03-15-2009 at 01:16 PM.
    R[a]ngl[e]r

  3. #3
    Senior Member ptgatsby's Avatar
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    Quote Originally Posted by TwinkleToes View Post
    1) We continually attribute market successes to "market timing", though the percentage of trained investors who can with some regularity find growing trends in the market to invest in is very very very small.
    By market success, I presume you mean investment success. The people who can predict it are exactly 0, as it is often below the expected return if they did not market time. Those that have success are the ones that win the lottery - a few get lucky.

    With the lack of connection between this ideal and the statistical proof of its existance, why do you think this myth is still propagated?
    It's not really that propagated anymore. Nearly all literature talks about not timing.

    The bias here is that humans think they have more competence and more awareness than we do, leading to people who think they can beat the market.

    2) Do you support the EFM? For what reasons? If not, why?
    I semi-support the EFM, because my experience has been that prices approach the risk-adjusted return the vast majority of the time. I don't support it because it's essentially meaningless - the time frame, the bubbles, and the variables (ie: risk, etc.) are all remarkably subjective... and present way too often.

    3) If you were to alter the EFM to be more accurate for real investing, how would you change it?
    I'd teach it in economics. Followed by the 11th rule in economics: do not use economics for investing purposes. Ok, I jest some. But that's pretty close to what I think. Economics measures what happens after it happens, then tries to explain why it happened. To some degree (and I don't mean all economics is like this) it's like dealing out a deck of cards. Economics can tell you about the dealer and why someone won/lost the hand, but it's relatively useless for the players trying to play their cards.

    There are notable exceptions... but what I have seen is that those familiar with economics vastly overstate their knowledge of financial matters. And that's giving economists the benefit of the doubt in being able to predict economic matters... something I'm not sure their track record bears out. However, I do blame politics for a large part of that.

    4) Do you perceive the market as rational?
    The market is made up of people, people are not rational, so the market is as rational as the group of people average out to "rational". Counter-intuitively, I'd say that makes markets pretty rational, as people acting in aggregate tend to respond to incentives more uniformly.

    The problem is that "rational" in aggregate is not the same kind of aggregate in individuals. Perfectly rational people can give rise to tragedy of the commons - which is generally an "irrational" outcome. Bubbles, in a similar way, are perfectly rational - so long as you see prices going up, keep buying! The large picture says irrational, but the individuals are still reacting to rational incentives.

  4. #4
    Order Now! pure_mercury's Avatar
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    I agree with what's written so far. People are not completely rational, and no one can ever no ALL the pertinent information about the market at any given time (hence constantly changing prices). However, the market IS the most efficient mechanism for determining prices and distributing that information through the market actors.
    Who wants to try a bottle of merc's "Extroversion Olive Oil?"

  5. #5
    Alexander the Terrible yenom's Avatar
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    Very informative. The whole notion of the market exists is BS though. I have yet to figure out what the market is besides the financial markets.
    The fear of poverty turns people into slaves of money.

    "In this Caesar there are many Mariuses"~Sulla

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  6. #6
    Senior Member Rangler's Avatar
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    Quote Originally Posted by untypable View Post
    Very informative. The whole notion of the market exists is BS though. I have yet to figure out what the market is besides the financial markets.
    Most markets, like the market for soft drinks, or steel, are regulated naturally through the capital markets. If one industry is profitable, they will get more capital investment. In this way, most markets feed into the capital markets. The efficiency of the capital markets is the essential issue.
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  7. #7
    Alexander the Terrible yenom's Avatar
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    hmm..I see. Thanks.

    Most economists refer to the market as the population and their needs as a whole, which can be anything.
    The fear of poverty turns people into slaves of money.

    "In this Caesar there are many Mariuses"~Sulla

    Conquer your inner demons first before you conquer the world.

  8. #8
    ish red no longer *sad* nightning's Avatar
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    I don't know much about marketing... but from what I observe... there is no "timing". This sounds horrible but most traders don't make money. Those that managed to make money doesn't have repeat performance the following year. That's what the study shows... it's all random chance. x-X

    Market/people is never rational anyhow... I guess if you can predict the general trend of irrationality in buyers... perhaps you can make money =/
    My stuff (design & other junk) lives here: http://nnbox.ca

  9. #9
    Alexander the Terrible yenom's Avatar
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    Quote Originally Posted by nightning View Post
    I don't know much about marketing... but from what I observe... there is no "timing". This sounds horrible but most traders don't make money. Those that managed to make money doesn't have repeat performance the following year. That's what the study shows... it's all random chance. x-X

    Market/people is never rational anyhow... I guess if you can predict the general trend of irrationality in buyers... perhaps you can make money =/
    the financial markets is motivated by greed. everyone invest money in stocks hoping the market price would rise. The market is a pretty random , anything can happen. But some people are good at speculation and make huge profits like george soros or warren buffet.

    as for the market in the real world, it does not exist. People rarely buy and sell all their goods openly in the streets as they did in the past. Most exchanges occur between businesses. I guess you can say that any form of exchange can be called the market mechyanism.
    The fear of poverty turns people into slaves of money.

    "In this Caesar there are many Mariuses"~Sulla

    Conquer your inner demons first before you conquer the world.

  10. #10
    Senior Member Rangler's Avatar
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    Quote Originally Posted by nightning View Post
    I don't know much about marketing... but from what I observe... there is no "timing". This sounds horrible but most traders don't make money. Those that managed to make money doesn't have repeat performance the following year. That's what the study shows... it's all random chance. x-X

    Market/people is never rational anyhow... I guess if you can predict the general trend of irrationality in buyers... perhaps you can make money =/
    You are partially correct. A lot of managers made money before the market went to shit, but the average manager cannot beat the market rate of return consistently. This is one of the stronger pieces of evidence that support efficient markets.
    R[a]ngl[e]r

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