Anti-EMH and Antitrust
Sumner amusingly analogizes opponents of the Efficient Market Hypothesis to proponents of antitrust laws:
You have to be impressed by the resourcefulness of the anti-EMH,
crowd. If LTCM and its merry band of Nobel-Prize winning economists
had actually beat the market, if they had used market anomalies to get
rich, well then it would have been the death knell of the EMH. Every
time Fama said “if you’re so smart how come you’re not rich,” people
would have responded that Scholes and Merton did get rich by spotting
market inefficiencies. Instead they failed miserably, and this shows .
. . it show that markets are inefficient because the market can stay irrational longer than you can stay solvent.
The more I study the psychology of the anti-EMH crowd, the more
surprised I am that anyone still believes in the EMH. It seems like
anything that happens undercuts the EMH. It reminds me of people who
see monopoly everywhere. High prices? Clearly monopolistic
exploitation. Low prices? Ah, that’s predatory pricing. The same
price as your competitor? Obviously price fixing.
My main complaint: Scott’s still not buying my simple modification that makes the EMH far more plausible. It’s pretty obvious that investors’ mood swings matter a lot. Why not just say that their mood swings are yet another important hard-to-predict variable that the best minds in the world struggle to forecast?
Feb 5 2010 at 4:41am
Certainly the EMH becomes more plausible if it is modified to incorporate investors’ mood swings. But when so modified it is very hard to distinguish it from Keynes’s beauty-contest model, in which prices are determined by what average opinion believes the average opinion to be.
Feb 5 2010 at 6:04am
I’ve commented before that defenders of the EMH retreat to this weaker version whenever the EMH comes under siege, and then use a different, stronger interpretation when they want to draw conclusions.
I mean, you don’t have to go very far to find out what the critics Sumner was paraphrasing were referring to. Here’s Eugene Fama himself, in an interview:
He doesn’t just want to say “you can’t make money off it”, he wants to say “there’s no bubble”. There you have it, folks: the strong version of EMH which doesn’t just say “you can’t make a profit”, but also says prices accurately reflect economic fundamentals at all times.
Raise your hand if you think there was no bubble. I mean, there are still Austrian readers on this blog, right? Not just cheap mockups of Chicago?
Feb 5 2010 at 8:13am
EMH stated another way is “people don’t consistently make the same mistake (in the same respect).” Telling a story about how people in general behave and positing a consistent mistake makes for a very strange story.
Feb 5 2010 at 8:48am
The issue is that there is a duality problem in finance.
To test if there is a bubble you have to have a correct model stock pricing. No such model exist.
But to test your model of stock prices you have to test if it predicts the market and thus assume the market is allways right.
When people say there is a bubble they are saying. I think prices are too high based on MY model of what stock prices should be. If they are willing to bet on that model and are correct they will make money.
Feb 5 2010 at 11:28am
“say that their mood swings are yet another important hard-to-predict variable”
Speaking of which, Prozac is one todays most widely used drugs. In addition to giving a general sense of well being and loss of anxiety, Prozac has been proven to affect risk taking. Patients don’t seem to calculate daily risks in quite the same way. Are there studies that measure this effect on the market?
Feb 5 2010 at 12:37pm
“Why not just say that their mood swings are yet another important hard-to-predict variable that the best minds in the world struggle to forecast?”
Because this would take away the random walk theory, and therefore the normal distribution, and all the mathematical sophistication thereby facilitated. They’d also have to allow technical analysis (ie. applied mood swing detection) into the weak form of the EMH, and academics have been bashing TA for decades. It would be tough on the ego, and think of all those text books you’d have to rewrite.
Feb 5 2010 at 12:46pm
Where is the evidence that “mood swings” are an independent, exogenous determinant of stock prices?
Feb 5 2010 at 1:33pm
Randolph Nesse asked Is The Market On Prozac? ten years ago. Richard Peterson mentions the effects of Prozac and other drugs on investor behavior here. Neither cites any detailed attempts to quantify the effects, though.
Feb 5 2010 at 6:13pm
Correct me if I am wrong but wasn’t the trouble at LTCM a temporary liquidity crisis, i thought i remembered reading somewhere that their positions would have been profitable in the long term if they had been able to sustain some losses in the short term. if so that would seem to indicate that they found genuine inefficiencies.
Feb 5 2010 at 10:37pm
Thanks Drawbacks. The Prozac thing is interesting although probably untestable. What would I do if I had the choice between two funds, one of which had a manager on Prozac and the other without? If athletes can’t be on drugs, should investment managers? It seems like the pressure and culture on Wall Street would lead to greater per capita Prozac use than some other places. Although I just read some old statistics that said there is a place with three times the Prozac usage of New York city, Utah.
Feb 6 2010 at 3:23am
The problem with mood swings is that, the mood cannot get arbitrarily bad or good, and therefore, mood swings imply mean reversion. So this makes prices predictable.
Feb 6 2010 at 10:42am
Felix: no it doesn’t.
Interest rate are pretty much bounded, they mean revert yet interest rate futures don’t because they look at a specific point in time.
Feb 6 2010 at 10:45am
A common point between anti-trust and anti-emh folks is that a similar answer can be addressed to them. Shut up and arbitrage, shut up and compete.
Feb 7 2010 at 1:14pm
Not sure why Scott should have to explicitly mention every unpredictable contribution to prices.
Feb 8 2010 at 4:12pm
Correct me if I am wrong but wasn’t the trouble at LTCM a temporary liquidity crisis, i thought i remembered reading somewhere that their positions would have been profitable in the long term if they had been able to sustain some losses.”
You are correct, LTCM main problem was they violated there own rules that they set-up at first. When the Russian Interest rates went out of whack due to the default, LTCM did not have enough cash to cover their positions. The banks and investors whole bailed them out ended making a nice profit.
LTCM main problem was they started violating their own rules they had set-up early because they got greedy. Why?, the interest rate arbitration profit that they had been making so much money on was going away due to other getting into the same market. So as to keep chasing the same returns they took on risk that that originally had serious rules against going into. This was the major cause of the cash problem that caused them to go belle up.
Read “Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It”. It is a great read from a story alone, let alone the business lessons.
Feb 8 2010 at 4:40pm
My take on EMH has been it is a principle not a law, violate at your own risk but you will be wrong some times if you follow EMH. It holds true most of the time, but if you are really smart and lucky at predicting when it wrong and will correct itself, you can make profits above the benchmarks. Evidence likes Shillers work on Stock Market Volatility, and the two recent bubbles lend evidence against EMH. I always find ideas which try to make laws out of collective human’s behavior silly. There are many principals that hold true most of the time about humans, but humans have a tendency to break molds when experience says otherwise.
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