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?
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?