The paradoxical efficient market hypothesis (2024)

Anyone who has lived through a market correction (the tariff announcements in early April this year being a recent example, though there have been far worse) should be able to see that market prices do not always accurately reflect even the consensus view of value (which itself can be wrong). As people are forced to de-lever, everything goes down at once, often by very similar amounts, even though it cannot be possible that everything suddenly lost the same amount of value simultaneously.

To quote Richard Bookstaber, "The principal reason for intraday price movement is the demand for liquidity... the role of the market is to provide immediacy for liquidity demanders. ...market crises... are the times when liquidity and immediacy matter most. ...the defining characteristic is that time is more important than price. ...diversification strategies fail. Assets that are uncorrelated suddenly become highly correlated, and all positions go down together. The reason for the lack of diversification is that in a high-energy market, all assets in fact are the same.... What matters is who holds the assets." (from A Framework for Understanding Market Crises, 1999)

Was the market drop an accurate reflection of the value that would have been destroyed by those tariffs, discounted by the probability that they would have been enacted as drafted? Nobody knew then, and I maintain that nobody even knows now. That was not the calculation that was being made.

> if a sufficiently large majority of investors believe the hypothesis, they naturally would assume that new information about a stock would very quickly be reflected in its price. They would conclude that since relevant news almost immediately moves the price up or down, and since new developments can’t be predicted, neither can price increases or decreases

This is an oversimplification of how professional investing works.

The vast majority of the dollar value of markets isn’t governed by immediate profit seeking behaviour - it’s people trying to manage money in the context of a real business. Pension fund money is the largest “pot” in the markets at any one time.

Pensions funds aren’t incentivised to maximise returns in any particular quarter/year. Instead, they’re looking to manage risk and ensure consistent returns in the very long term.

Therefore, the “value” they place on various assets is different to what a trend fund or retail investor is thinking about. The price at which they would buy/sell is different.

The market value might “reflect” that information but it could easily create a situation in which short-term, strictly returns-motivated investors might value an asset much more than pension funds or vice versa. That creates opportunity for both to do a non-zero-sum trade and both “make money”.

I’ve seen it elsewhere in this thread but it’s simply not the case that the “markets are a casino”. The vast dollar value of the market is about sharing risk and providing liquidity.

The global bond market are at least 1.5 times the size of the equities market(s).

yes some markets are basically a casino but they’re tiny in comparison.

    the hypothesis maintains that
    stock prices reflect all relevant
    information about the stock

What if it takes 12 months of hard thinking to draw the right conclusion from the information? Are there many investors who go to such lengths? Are they all thinking at the same speed? And if not, what does that tell us about the EMH?

Google released DeepDream in 2015. My feeling is that with enough thinking, one could have predicted where image generation is going in the next decade and that language generation would go a similar route. And that this will lead to a high demand in Nvidia's GPUs. But that thinking would not be instantly. It would take months or years.

Sir this is just a casino. Stocks have nothing to do with the businesses right after they are issued. A business can opt to just never issue dividends (Hi Amazon). So the stock itself has 0 actual value. It does not generate cash. (Ok if the company goes belly up you will get a percentage of the carcass)

But we can all gamble on what it is worth!

So stockholders are like roulette pill holders. Everyone just bets on where the pill will fall. Few are luckier than others. Some smarter know whether the roullete is rigged and have better chances.

This seems to be a case of a feedback loop creating emergent behavior.

Let's say almost everyone believed in the Efficient Market Hypothesis (EMH). Then, trading would decrease significantly, since most people would think that stocks are already fairly priced. That means the few people who trade would move the market significantly, based on whatever idiosyncratic value-theories they had.

But then the EMH believers would see wild moves in the market and stop believing in EMH. They would start trading more to gain profits.

And as more traders participated, the market would behave more and more like the EMH were true. Eventually, the market would stabilize. Prices wouldn't swing so much. This would increase the number of EMH believers.

It would be interesting to survey belief in EMH among traders. If my model is correct, the percentage of EMH believers should be roughly constant, or at least oscillate around some optimum value.

The efficient market hypothesis is a useful framework to understand complicated dynamic markets, but like almost all economic theories it isn't like a law of physics that explains reality 100%, but is a partial abstraction that explains key patterns of human behavior and information flow within markets.

You can think of it like a form of compression: it condenses an incredibly complex, chaotic system into something we can reason about. That simplification makes it powerful and insightful, but it also means that a lot of nuance and unpredictability are lost in the process. In contrast, a physical law can be calculated precisely and consistently, while market behavior is always shaped by human psychology, uncertainty, and imperfect information.

I have just written an post on technical analysis that presents a balanced perspective on the Efficient Market Hypothesis, the Random Walk Hypothesis, and their relationship to practical applications. I explore how retail traders identify patterns, how these patterns may be exploited in high-frequency trading, and how machine learning contributes to detecting and leveraging such patterns. In case someone is interested: https://beuke.org/technical-analysis/

Information characterizing a company’s value isn’t the same thing as information indicating a company’s value. There can be a lot of analysis and model building in between. And different models can behave very differently, even if their prediction strength is similar.

Information publicly available doesn’t mean anyone can process it all. Every actor is operating off a different subset of information.

Lots of intentionally low information investors (inhabitants of indexed funds) demand stock or supply stock, pushing prices in directions unrelated to value changes, due to index list changes and rebalancing events.

Investors, of all magnitudes of wealth, have unending personal or private idiosyncratic reasons for the timing of many investments or sales, besides individual asset return optimization.

The value of a stock rises and falls as its absolute expected return rises and falls relative to the changing returns of the rest of the entire market of investment vehicles. Everything impacts everything.

All these shifts happen over varying time frames.

Almost all relevant market facts are time varying, often with turbulence and ambiguity.

The fast moving investors most influential in setting prices, must model the whole market’s 2nd order and even 3rd order reactions (by similar actors) due to feedback effects and dynamics.

Sudden market wide changes trigger waves of low analysis buying and selling. Compounded by the higher order risk this creates to leverage, annuity responsibikities, hedging, and many other amplifiers of behavior.

The efficient market hypothesis is an interesting and enlightening thought experiment. A reduced dimension toy/sim market.

Not a credible model.

Not even if every single participant was frantically and relentlessly re-valuing and re-balancing at the margins to a firehose of comprehensive market information.

I think what is unquestionable is that statistically, given available information, it is hard to make money against other market participants.

It is a form of informational efficiency, but it does not necessarily follow that prices are even statistically correct. The market can be irrational for longer than you can remain solvent.

My practical interpretation of the EMH is more that easily accessible, public information is already priced in. But non-obvious insights may not be simply because the volume of people trading on that information will be smaller.

Does the EMH state that prices will reflect on the price of a stock instantly? If not, I don’t think there’s a paradox. EMH would just mean it will eventually converge? I guess that makes it pretty toothless in practice then.

I feel like the stock market is pretty divorced from fundamentals at this point i.e. speculation makes it more like a Keynesian beauty contest (picking stocks you think other people will think are valuable).

https://en.m.wikipedia.org/wiki/Keynesian_beauty_contest

The EMH is a description of how the market behaves when a sufficiently large number of independent actors are looking for alpha. It is not a prescription of how the market should behave.

The conclusion is that with a sufficiently large number of actors in the market all seeking profits by trying to find misevaluation of stock prices, the excess profits of any individual actor will (assuming they all have access to the same information) converge to zero.

Its less a paradox and more a matter of game theory. Every investment firm which gives up trying to look for alpha (believing it is fruitless) means the remaining firms have more opportunities to find stocks with available information not reflected in the price. There's no paradox here: each individual actor is incentivized to participate in order to not miss out on that potential for excess profits, and the net effect is the EMH.

The EMH is obviously bs, as anyone with an ounce of common sense can observe from today’s market. To appeal to authority, buffet and monger and graham point out how insane Mr Market is, and they’ve done pretty well by exploiting its inefficiency.

Market prices are derived from supply and demand. A heavy determinant of demand is income equality. Another is interest rates. These are nothing to do with, in general, a particular stock.

It’s so obviously false to anyone trading or even watching stocks that serious discussion by academics just adds weight to the accusation that they don’t know what they’re talking about. We need a new, more serious, science of economics.

See also:

> The Grossman-Stiglitz Paradox is a paradox introduced by Sanford J. Grossman and Joseph Stiglitz in a joint publication in American Economic Review in 1980[1] that argues perfectly informationally efficient markets are an impossibility since, if prices perfectly reflected available information, there is no profit to gathering information, in which case there would be little reason to trade and markets would eventually collapse.[2]

* https://en.wikipedia.org/wiki/Grossman-Stiglitz_paradox

So the more efficient markets are, the hard it will be to find "alpha" (returns), and so more people will stop trying. But as more people stop trying, markets will become more inefficient, in which case people can find alpha again, which encourages more participants.

I think the valuations of dogecoin and fartcoin don't fit well with the efficient market hypothesis. They both have no assets and no profits but fartcoin is valued at $668 million and dogecoin at $39 billion. Surely in a rational market fartcoin should be valued at more as it has a funnier name?

Slightly more seriously his assertion:

>Alternatively stated, the Efficient Market Hypothesis is true if [...] a sufficiently large majority of investors believes it to be false.

is flawed. They could believe it false but still make a mess of the valuations. Which can cause real world problems if profesional investors put your pension money into webvan or other bubble stocks and then there is a cash shortage after the dot com bubble burst. Of course they are wiser now and won't make such errors with AI.

Any hypothesis based on false assumptions is a priori false, and the EMH is filled with false assumptions.

It makes no sense because people do not acquire information at the exact same time, nor do they act on it with the same amount of force, i.e., capital.

It’s the same stupid people who say the market is a random walk. Oh yeah, if it was a random walk, then why do earnings reports even matter? Companies could just lose and gain whatever they want, and stocks would just fluctuate randomly.

Here’s the truth. It’s called Rice’s theory of opportunity. It says that there is a golden window on the order of a few weeks to a few months where the signal-to-noise ratio has the least attenuation. This is because it avoids the initial transitory periods, the real-time gap between the knowledge existing and the knowledge spreading to people with enough resources to make a difference.

For this paradox to function, information would have to be static, unless I'm missing something.

I forget where I first heard it, but there's a joke about two economists walking down the street. One of them notices a $20 bill on the ground and points it out out, saying "Look, it's $20 just lying there on the sidewalk!" The other shakes his head and says "No, that can't be true; if it were, someone else would have picked it up already"

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EMH is nonsense that is repeated routinely to scare people from trading the market.

Nancy Palosi.