Philip Pilkington: The Efficient Markets Hypothesis Has Been Proved Wrong But Economists Do Not Want to Listen

Yves here. The Efficient Markets Hypothesis, along with the Capital Assets Pricing Model, is one of the cornerstones of financial economics. Pity both are wrong.

Actually, it’s worse than a pity, since financial economics informs not only how professional investors construct their investment portfolios, but similarly is the foundation for orthodox thinking among retail investors. And the Efficient Markets Hypothesis and the Capital Assets Pricing Model both understate market risk, so following their dictates leads investors to take on more risk than they intended to.

The line of thought that was later codified as the Efficient Markets Hypothesis was first put forward by a French mathematician, Henri Bachelier, in a PhD dissertation in 1900. His ideas remained fallow until the 1950s, when they were discovered and put forward by Paul Samuelson in a thesis on option pricing. It was then developed further by Samuelson and Eugene Fama. Our summary from ECONNED:

The efficient markets school of thought holds that market prices reflect current information. The weak form of this theory is that past prices have no predictive power; you can’t cut market data to devise a winning long-run strategy, which contradicts the beliefs of market technicians, who look to historical patterns for guidance. The semi-strong form holds that prices move quickly in an unbiased manner to incorporate new information, so investors cannot make money trading on news. The strong form states that prices incorporate all relevant information.

This construct alone has had considerable impact, since the implication is
that investors cannot consistently beat the market.

Yet the Efficient Markets Hypothesis and the Capital Assets Pricing Model are still almost universally taught and used despite serious (and in the case of CAPM, fundamental) flaws. People apparently would rather have bad heursitics than none at all.

By Philip Pilkington, a London-based economist and member of the Political Economy Research Group at Kingston University. Originally published at his website, Fixing the Economists

The Efficient Markets Hypothesis (EMH) is wrong. It has been proved wrong. Do you think you’ve heard this before? You likely have, but the proof that you’ve heard that the EMH is wrong probably has not done the damage that you thought it had.

When I studied the EMH for my dissertation I noticed that many had thought that the financial crisis of 2008 had proved the EMH wrong. In one way this was true. Investigations undertaken by the authorities had uncovered that people within many markets were actively misleading the public about the underlying value of securities.

After being told that a security was not structured properly an S&P official said that they would rate it regardless. “We rate every deal. It could be structured by cows and we would rate it.” If the EMH says that markets price in risk perfectly then the markets were not operating in the manner the EMH predicted in the run-up to 2008.

Nevertheless, this mattered little for the other claim made by the Efficient Markets Hypothesis proponents. The EMH proponents said that you cannot beat the market consistently. Because all information is already priced in then any gains you make over the market will only be temporary. If you beat the market this year, the chance that you beat the market next year will be extremely low. If you beat the market both this year and next year then the chance that you will beat the market the year after will be lower still. Using this reasoning you will, in the long-run, be completely unable to beat the market.

I found this reasoning terribly troubling. First of all, just because most people cannot beat the market does not mean that the EMH is correct. A number of other hypotheses could also be correct. For example, the Post-Keynesian proposition that the future is inherently uncertain and thus that predictive techniques of complex market dynamics will likely fail could also be confirmed by the same observation.

Secondly, the proposition struck me as being tautological. Who was the ‘you’ in the statement ‘you cannot beat the market’? It seemed to me to be the idea of an ‘average investor’. But, as everyone knows, ‘the market’ is simply the outcome of the average decisions of all investors taken together. Thus, ‘the market’ is actually the expression of ‘the average investor’. The two terms — ‘the market’ and ‘the average investor’ — are actually synonyms. So, the statement ‘the average investor cannot beat the market’ could just as easily be read as ‘the market cannot beat the market’ or, alternatively, ‘the average investor cannot beat the average investor’. This struck me as being a purely tautological and highly problematic approach to studying markets. It appeared that EMH proponents were confusing the idea of the ‘average investor’ with any given ‘particular investor’.

Thirdly, tied to the second point and most importantly, it appeared to me that many people do indeed consistently beat the market. The probability of someone like Warren Buffett existing seemed to me, from an EMH perspective, entirely implausible. But then I found something even more unlikely: John Maynard Keynes had, in the 1930s, effectively tracked Warren Buffett’s stock market performance. In the graph below you can see Keynes’ investments plotted against both Buffett’s and the market return in his own time.

keynes-buffet comparison chart

As John Authers wrote in his article ‘Keynes Stands Tall Among Investors‘ when he compares Keynes with Buffett:

What of Warren Buffett, the world’s best-regarded investor? The chart shows how the portfolio of Berkshire Hathaway, his main investment vehicle, has performed over the past 22 years – and the King’s endowment under Keynes did better. Had we chosen the first 22 years of Buffett’s tenure, when his portfolio was smaller, making it easier to outperform, Buffett would be ahead. But Keynes’ record places him in exalted company.

Now, this seemed to me beyond a coincidence. Maybe you could make the case that Buffett was an anomaly, an outlier on the probability map, but Keynes? This seemed doubtful. Was it merely a coincidence that one of the greatest and most famous economists of the 20th century — one who emphasised the unpredictability of the future and the irrationality of the financial markets — was also able to beat the odds? This seemed highly improbable.

But the plot thickened as I pursued this further: it seemed that Keynes had used a very similar investment strategy to Buffett. While in the 1920s he had tried to play some silly mathematical games he had lagged the market. But when he switched to the strategy that Buffett uses he saw his gains soar. Authers writes:

His performance lagged the market in the 1920s, when he used an elaborate economic model to time the market. It did not work, and he failed to spot the Great Crash coming. He admitted that this approach “needs phenomenal skill to make much out of it”. So he switched to picking stocks. Like Buffett, he said he became ever more convinced that “the right method in investment is to put fairly large sums into enterprises one thinks one knows something about”. His results speak for themselves.

Could this all be coincidence? It seemed to me that it probably was not. And then I stumbled on a famous 1984 article by Warren Buffett himself entitled ‘The Superinvestors of Graham-and-Doddsville‘. In the article Buffett discussed a group of nine investors who had substantially outperformed the market in a 20 year period. He accepted that these could all be simple probabilistic anomalies — black swans, as it were — but he noted one important point: they all came from the same school of investing.

Now this did not mean that they all bought the same assets. If they had that would explain the anomaly. But they did not. They all had different strategies and they bought different assets. But they all followed the same philosophy.

As Buffett said in the piece: if there were 1,500 cases of a rare cancer in the US and 400 of them were in a small mining town in Montana good scientists would probably go to the mining town and check the water. Economists do not do this type of research, however, which is what critical realists and other critics of econometric/probabilistic approaches (present writer included) always complain about. But if they did do true scientific research Buffett’s article would interest them greatly.

Looked at from anything resembling a scientific approach it is quite obvious that Buffett’s article proves the EMH completely wrong. It is also interesting that the investment strategy that Buffett, Keynes and the nine other investors discussed in Buffett’s article runs exactly contrary to the EMH assumption of information being priced into markets at all times. Indeed, their investment strategy rests on the idea that market prices often diverge substantially and for long periods of time from the underlying value of the assets.

So, what have the economists said in response? Nothing. Not being scientists but rather moralists and soothsayers they simply avoid contrary evidence when it is presented to them. As the investor Seth Klarman wrote in his book Margin of Safety:

Buffett’s argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what was refuted in practice. (p199)

Economists and business schools continue to teach the Efficient Markets Hypothesis, of course. It continues to give off the mystique that markets somehow get the price ‘right’. It does so by being vague to the point of meaninglessness in many cases. But when it does manage to say something concrete and make a claim that can be falsified, it fails. And when it fails its proponents simply ignore the overwhelming evidence to the contrary. This is not science. It is ideology.

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  1. Legion

    People who needed a theory like The Efficient Markets Hypothesis to be proven wrong, almost deserve to be led astray by it.

    1. Matthew

      Honestly. If there’s one thing that primitive accumulation makes clear is that capital makes and breaks its own gospel/rules with impunity whenever that suits. The system begins with massive land theft and enslavement, and can often only work its way out of the regular crises that come WITH such unequal accumulation with plenty more of the same. War, of course, is often the pretext for these. It’s the unfortunate role of too many bright lefty economists to make this discovery over and over without ever coming close to the obvious implications. Out of a job is not a nice place to be.

  2. John

    Rigid ideology drives the profession. Case in point is Ferguson. It is receding into history, yet we have few economists laying out a study on (linking) the implications facing the town to the larger economy. But when Yellin utters (signals) a few sentences, they are all over it. The soothsayers are AWOL when it comes to putting something down to address the inequality issues facing people of color. Race is still too taboo.

  3. Ben Johannson

    Next you’ll be arguing that DSGE models aren’t useful, either. Yes, admittedly they haven’t been in the past, but a couple of dudes plugged in variables for finance while continuing to confuse uncertainty and risk and making assumption which don’t account for shifts in probability distributions, so now everything is fixed!

  4. craazyman

    If anybody out there wants to beat the market, just do the opposite of what I do. For a negotiated fee in the low 7 figures (not including tenths and hundredths), I’ll let you see my trades in real time. If you do the opposite, leveraged to the max, you’ll score a 10 bagger in a year.

    The EMH is weird, saying the market is the most efficient portfolio. If I could somehow take a cocker spaniel public with the idea he’d be the next “Lassie” (if anybody remembers Lassie), not buying a piece of him would be inefficient. PT Barnum said “a sucker is born every minute”. Both EMH and PT Barnum can’t be right. I think PT Barnum has the higher cred.

    Phil the idea is right but the math’s related a tad wrong. Each year is theoretically independent probabilistically. Like flipping a coin. If you flip 4 times and get heads, it doesn’t mean the 5th flip is likely to be tails. The odds are still 50/50. However, it’s unlikely you’d get 10 heads in a row due to the laws of chance over larger sequences of trials. So if you beat the market 3 years in a row, the chances in the 4th year are still 50/50 — assuming you’re just guessing.

    This means you can start with 1000 investors and due solely to laws of chance, after 1 year 500 beat the market, after two 250, after three 125 etc. etc. After 7 or 8 you’ve got a handful of “geniuses”. How do you know if they’re just lucky? it’s not easy to tell. How do we know Buffet and Keynes weren’t on the far margins of luck? I doubt either is just lucky, but mathematically it’s hard to prove.

    There’s actually a pretty rich (no pun intended) academic/practitioner literature on beating the market through factor-based investing, beginning with the Fama-French 3 factor model that emphasizes a value-factor, sort of a highly diluted and genericized version of Graham-Dodd/Buffet/etc that relies on laws of large numbers emphasizing portfolios built from companies that score high on value factors.. However since this is academic finance and not economics it may not register that high among economists. Also, this stuff can be ground down to mathematical dust and still be controversial. Tastes great vs. less filling.

    1. Philip Pilkington

      Re: maths. I don’t think that I said otherwise. The probability of each individual “beating of the market” will always be independent. But the compounding of these “beating the markets” will not.

      If I flip 9 heads the probability of the next flip being heads is 50/50. But the chances of me flipping ten heads is 0.5^10. That is 1/1024, I believe.

      The chances that Warren Buffett exists and has accumulated the level he has accumulated is probably quite an incredible number. I wonder if anyone has ever tried to calculate it.

      1. Philip Pilkington

        And actually I just reread that. Your example is not correct. People do not have a 50/50 chance of beating the market every year. You seem to be taking the coin toss example and then applying it to the chance that a person can beat the market. The two are not synonymous so far as I can see.

        1. craazyman

          If they did the exact opposite of what I do, they’d beat the market more than 75% of the time.

          The other “fun with math” thing is this:

          Two dudes start with $100 and decide to get rich.

          Dude A gets lucky in year 1 and doubles his money to 200.
          Dude B gets unlucky and ends up with 75.
          Then they both earn same return for 20 years (say 5%), because both decided they’d rather lay around doing nothing than work at getting rich and lost any interest in wealth.

          Dude A ends up with 200 * (1.05)^20 = $530
          Dude B ends up with 75 * (1.05)^20 = $199

          Somebody looks at this and says to themselves without knowing the history “Dude A is a waaaay better investor than Dude B! Everybody can see that.” haha

          1 lucky year. You gotta get lucky, that’s it. Getting lucky is the secret to success. Or earning fees. Luck or fees, that’s the way to go.

      2. Demeter

        “The chances that Warren Buffett exists and has accumulated the level he has accumulated is probably quite an incredible number. I wonder if anyone has ever tried to calculate it.”

        It’s only incredible if you don’t see the strings being pulled in the background. Remember: “Behind every great fortune lies a great crime.” – Honore de Balzac.

    2. skippy

      Thought by now people would have learned the lesson of not applying game theory to human activities, especially when you incorporate agency problems [ummm… massive control fruads, coercion, indoctrination, et al].

      For a real good time try the zero determinant strategies eventual outcomes from a biological outcome, it strangely mirrors the direction we seem to be heading… extinction…

    3. just bill

      A guy I knew put $200k into gold stocks in 1979, then moved into options in 1980. By September he had $4 million, and by February he had nothing but a big screen TV. That was efficient!

    4. lyman alpha blob

      Might be misreading what you’re trying to say and talking past you a bit – that being said maybe each year is ‘theoretically independent’ but that theory is wrong. You can’t assume a normal gaussian distribution for picking investments – it doesn’t work the same way as flipping coins.

      I found Benoit Mandelbrot’s ‘The (Mis)Behavior of Markets’ where he discusses the problems with assuming a normal distribution to be a very good read. And if I’m remembering it correctly (been a few years since I read it) he does prove mathematically what you mentioned above. Written 4 or 5 years before the most recent meltdown, he shows that on any given day or year the market or a stock does NOT always have a 50% change of moving up or down – if a stock goes up for a couple days in a row it there is actually more than a 50% chance that it will go up the 3rd day. Past results CAN determine the future because human beings are not inanimate objects and psychology comes into play.

      Sure looks like Mandelbrot was right, which is why he will probably be remembered more for his contributions to mathematics (fractals among other things) than to economics (dropping a turd into the Friedmanite punchbowl).

    5. pat b

      One can argue that a very good diverse index portfolio with minimal costs will track the market, nicely,

      vanguard does that all the time.

  5. Banger

    People apparently would rather have bad heursitics than none at all.

    Yves, that statement says volumes and certainly explains a lot about the economics field and many others. We want things to make sense but we ““….cannot bear very much reality.” (T.S. Eliot)

  6. GlassHammer

    “It continues to give off the mystique that markets somehow get the price ‘right’. It does so by being vague to the point of meaninglessness in many cases.” – Philip Pilkington

    Hmmm…..I wonder if anyone could stand to benefit from a profession that preaches “markets somehow get the price right”.

  7. Ignacio

    There is no need to apply maths to discredit any Efficient Market Hypothesis. It is enough to remember the meaning of words. Interestingly, “efficient” does not mean the same in, for instance, english or spanish. In english, according to Webster’s, efficiency is “he ability to do something or produce something without wasting materials, time, or energy”. The idea that “Markets” do whatever without wasting, time, energy, materials or humans is ridiculous by itself. However, in spanish, efficiency is “the ability to mobilise resources for a given purpose and get it” and in this sense markets can be regarded as efficient (at least sometimes). Nevertheless, it is impossible to be efficient all the time as experience shows.

    1. hunkerdown

      However, in spanish, efficiency is “the ability to mobilise resources for a given purpose and get it”

      False cognate?

      1. capacity for producing a desired result or effect; effectiveness: a remedy of great efficacy.

      I can see how English “efficiency” (in the sense of economy or thrift) would be useful on an island cursed with arrogance, a sadistic sense of desert, an obsession with loyalty and pecking order, and a long-developed seafaring tradition. I can see how the other would be useful in a society of people who want to live together on and of the Earth and not hassle one another any more than necessary. I can see how having both definitions in use is awfully convenient for neoliberals with a bill of goods to sell.

  8. Jim Shannon

    “….cannot bear very much reality” (T.S. Elliot)
    If you took the corruption out of America, there would be nothing left. No economic model can possibily factor in or out what government cannot or will not regulate, prevent, or prosecute, and the consumer always pays as the cost of corruption is shifted to them.
    Always and everywhere it is about the money and who gets to keep the most, and that is always determined by the government.

    1. fresno dan

      Agree 100%
      ” found this reasoning terribly troubling. First of all, just because most people cannot beat the market does not mean that the EMH is correct”
      The question is, does Goldman Sachs beat the market? I forget the year – was it 2011 where they had their biggest bonuses ever? Now, is this because they really analyze how the economy works, know things, and understand the affect on prices of financial instruments??? Or are they just grifters? You know, I read an interesting article once about how Israel has undercover agents in its prisons to get information from Palestinian prisoners. This is actually well known by the Palestinians, but despite this information the prisoners still talk about Palestinian fighters, locations, etc. – apparently just due to the human nature of having to talk to someone.
      I think it is pretty well known that Goldman Sachs simply milks their customers – how many emails about “muppets” does one need (by the way, don’t most companies???) – so do humans just need someone to talk to about investing???
      So… Goldman Sachs profitable? Maybe, but I could be fantastically profitable too if I got to keep my gains and the government took my losses….
      And how about Warren Buffet? Just buy and hold? Of is the use of complex financial strategies, tax manipulation, etc a much more major part of it? (not that I blame him, but it sure doesn’t seem he uses the EMH)

      By the way, if the EMH is right, why would it make sense to ever “rebalance” between bonds and stocks????

  9. James Cole

    Even if it were not wrong in the way this article says it’s wrong, the EMH would be of very little importance or use if people thought about it the right way. In a market such as the securities market, there is no actual price at any given moment, there are just the most recent transactions plus the current order book which can change in an instant. So the notion of there being an actual price at any given moment is a myth to begin with.
    Further, what matters to participants in the market is not so much the “price” at a given moment but how the price moves and what the underlying topology or sociology of how news is transmitted to and among market players, and whether you can react faster than others to the news. For example, if IBM announced cold fusion, their stock price would increase, which the EMH would accurately predict. But what matters is, who captures the gains that that price increase represents? Say I am holding IBM stock and have posted an offer to sell and then this news is announced; if I do not react quickly and withdraw my offer or increase my offer price, someone who reacts more quickly to the news is going to accept my offer to sell and then reap the profit from the price increase. If I can react faster, I adjust my sale price upward and reap the profit myself. So yes, by the end of that little dance, “all information has been priced in” but that says absolutely nothing about the distribution of profit and loss resulting from the new piece of information about IBM.

    Now ponder the institutions that make up the market and consider: is the distribution of resources, personal networks and market infrastructure is such that it would in fact reliably distribute information, and therefore profit and loss from market moves, in a random or unbiased or remotely fair process? The EMH says nothing about that and is itself a deliberate obfuscation of these mechanics.

  10. Jim Haygood

    Yves’ intro takes a potshot at CAPM, but CAPM isn’t addressed here by PhilPil. Guess that’s another article.

    Give me an alpha, give me a beta …

    1. Yves Smith Post author

      We covered that in ECONNED too. Sharpe admitted in 1970 that CAPM didn’t work but advocated for its continued use anyhow (back to the “bad heuristics are better than none” notion):

      Another fundamental proposition in CAPM was that that investors could borrow unlimited amounts at the risk-free rate. Even Sharpe himself acknowledged that making that assumption more realistic, namely, that real-world borrowers pay a premium to the U.S. Treasury, face credit constraints, and pay even higher premiums with more leverage, was fatal to his construct:

      The consequences of including such aspects of reality are likely to be disastrous in terms of the usefulness of the resulting theory. . . . The capital markets line no longer exists. . . . Moreover, there is no single optimal combination of risky securities; the preferred combination depends upon the investors’ preferences. . . . The demise of the capital markets line is followed immediately by that of the security market line. The theory is in a shambles.

      At that time (1970) Sharpe nevertheless argued for continuing to use CAPM, invoking Friedman’s endorsement of unrealistic assumptions and the belief that even a flawed theory was better than no theory.

      And Fama and French later wrote the famed “Beta is dead” paper…..

      1. craazyman

        “The model doesn’t describe reality, the model creates reality.”
        -Professer D. Tremens, NFL, GED, U of Magonia

        The man bent over his guitar,
        A shearsman of sorts. The day was green
        They said, “You have a blue guitar,
        You do not play things as they are.”
        The man replied, “Things as they are
        Are changed upon the blue guitar.”

        -Wallace Stevens, Man with the Blue Guitar

      2. Jim Haygood

        ‘And Fama and French later wrote the famed “Beta is dead” paper…..’

        Indeed they did, to advocate replacing the simple one-factor beta model with a three-factor model which includes SMB (small [market cap] minus big) and HML (high [book to market] minus low). Then Carhart came along with his four-factor model, extending Fama-French with a momentum factor.

        None of these models fully explains portfolio returns, but multi-factor models can explain more than the single-factor CAPM. That doesn’t make CAPM wrong; just incomplete.

        We should not underestimate the insight provided by the Capital Market Line in defining T-bills as the riskless asset, and asserting that an investor can adopt a mix of riskless and risky assets. In the 19th century, fixed income investors exhibited a distinct preference for long-maturity bonds over short-maturity bills. Under the gold standard, long rates mean-reverted, so there was little or no concept of long Treasuries being riskier than T-bills, as everyone accepts today.

        The Sharpe ratio is still a basic tool in portfolio management. In an essay arguing for a broader concept of risk than volatility, Howard Marks of Oaktree Capital observes,

        ‘Investors can calculate risk metrics like VaR and Sharpe ratio (we use them at Oaktree; they’re the best tools we have), but they shouldn’t put too much faith in them.

        ‘Adding a few ‘risky’ assets to a portfolio of safe assets can make it safer by increasing its diversification. Pointing this out was one of Professor William Sharpe’s great contributions.’


        Two mentions of Sharpe from this prominent fund manager, but none of Fama-French or Carhart. Maybe simple tools are the best tools. If you can only pick one factor, volatility is the one you want.

  11. Ulysses

    Great comment! Unequal access to relevant information, and unequal capacity to quickly take advantage of new information goes a long way to explain how today’s markets are efficiently rigged to favor a handful of big players. This is nothing new. Nero and his cronies were able to make huge real-estate fortunes off the massive wave of arsons in Rome that they knew about in advance, Rockefeller managed to buy land that the railroad was going to need before anyone else knew of the railroad’s plans, etc.

    This doesn’t mean that a relatively honest approach of carefully studying certain business sectors, and investing heavily in well-run enterprises that are not yet famous, cannot also work. I confess to not knowing enough to pass judgment on whether this is actually how Messers Keynes and Buffet achieved their extraordinary investing results. I agree with Craazyman that there is a huge element of luck involved in any sort of speculation. I myself have only laid wagers at the horse track a handful of times. In every single instance I was extraordinarily lucky, so that my lifetime experience as a speculator, in the future outcomes of horse races, has me receiving hundreds of dollars in gains while only risking dozens of dollars in capital.

    My big secret? I always bet on the horse that had what I thought was the coolest-sounding name. I didn’t look at the forms, or do any kind of diligent research into the histories of the horses or jockeys involved. You are all welcome to use my “method” at the track of your choice!

  12. just bill

    Just about anyone who plays the market can win for a while with any strategy. The problem comes when he owns a stock that begins to tank. Most are unable to cut losses, myself included, which is why I quit playing.

  13. susan the other

    Why don’t analysts ever look at scale? The efficient market hypothesis sounds reasonable enough if you’re talking about some little, maybe subregional, place where there is a manageable amount of enterprise going on. But the minute all those little markets centralize into a few big ones, the old rules no longer apply. Even though there is no apparent reason why not. It’s like “capitalism” (whatever it really is) is a sorta organized system for doing business which is orderly and rational on a very small scale – but the minute it starts to grow exponentially all bets are off.

  14. Ed

    I never was comfortable with EMH, but its only now occuring to me how strange the claim is.

    In classical economic theory, buyers get different utilities from different goods, which is one reason for price differentials. EMH gets around this because everyone wants to see their securities later for a profit. But maybe not. Though dividends are priced into most pricing models, different investors have different time horizons, plus there are tax and regulatory differences between markets and investors. Companies buying back their stock have different prefereces to day traders to people trying to amass a college fund. So there is no average investor.

    But I think the main problem is greatly underestimating the extent to which people can keep quiet about critical information.

    1. James Cole

      You are confusing utility (which economists equate with happiness, or at least fungible types of happiness), with dollar profit or return. EMH says nothing about the distribution of utility, only about the distribution of profit and loss.

  15. Blurtman

    CAPM was one of the first topics covered in the first year finance class at the UC Berkeley MBA program when I attended. It seemed like absolute nonsense back then, as did most things that the program tried to pass off as knowledge. And, yes, I did take a course taught by Janet, which was interesting in a liberal arts kind of way.

  16. Bruce Wilder

    I find this blogpost by PP quite disappointing. Usually, I think PP is doing a credible job of critical translation of the doctrines of mainstream academic economics, and charting how those doctrines get transformed into neoliberal ideology. This blogpost, though, is a mess.

    First of all, let’s recognize that “The Efficient Markets Hypothesis” is NOT a theory. It is, as its name would seem to announce, an hypothesis. More specifically, the seminal paper by Fama, addresses a technical issue concerning how to conduct research into financial market functioning, using historical records of financial market prices. Because such records are freely or cheaply available, and would seem amenable to the skill set of graduate students trained in econometrics, there’s been a lot of interest in using them, quite apart from whatever issues of substantive importance might be tested. Technically, following scientific method, and Popperian conventions for the same, the EMH is the null hypothesis for such research. It is how the researcher formulates a statement, which the researcher is formally trying to disprove.

    Second, let’s recognize, as well, that the transformation of the EMH from a research technique into an ideological assertion that financial markets are efficient is doing severe violence to public (and political) understanding of the economics of financial markets and financial economics. An assertion, ideological or not, that financial markets are (informationally or substantively) efficient, as a matter of fact, is just stupid. Not because financial markets are obviously efficient or obviously inefficient — but, because financial markets are obviously efficient only in matter of varying degree.

    To keep some perspective, it helps to remember what we would, ideally, want economics to do for the public discourse, which is to inform political deliberation and the resolution of political conflict, not legitimate rank stupidity and public policy incompetence. The most obvious heuristic points concerning the (informational) efficiency of financial markets are 1.) it is, presumably, in the public interest that financial markets be efficient, and 2.) that actual, institutional financial markets will be only somewhat efficient, and that degree of efficiency will vary with the details of institutional design and management.

    What’s wrong with the line of research using the EMT as a technique is that it has gotten stuck doing an essentially qualitative test: answering a binary, qualitative question: is the historical pattern of price consistent with “efficiency” as a quality (whether “weak” or “strong”, still a quality, not a quantity, not a measured magnitude, not an answer to the practically important questions, “how efficient?” and “what about the institutional design and management made it that efficient?”

    That line of research may have gotten stuck, because it was hijacked for ideological purpose. It would be inconvenient to the neoliberal program, for economics as a discipline and a research program to seem to suggest that the efficiency of financial markets depends on the regulation, design and management of financial markets, making regulation, design and management a subject of public policy.

    The key point that I would want to make here is that the kind of assertions and statements that are used to hijack EMH — or any intellectual concept — for an ideological purpose, are not to be regarded as scientific. When Herbert Spencer coined the phrase, “survival of the fittest”, as part of constructing his ideology of social darwinism, he wasn’t making an accurate re-statement of Darwin’s scientific theory of biological evolution; the inaccuracy and vividness of the phrase served Spencer’s purpose, but disproving Spencer would not disprove Darwin. Just so, some of the popular ways of explaining the “meaning” of the EMH are simply means of transliterating the EMH (and, under its cover, the related doctrine of rational expectations) into an ideological assertion.

    EMH, as a technique for doing research, that is, as a way of formulating a null hypothesis, does not have much in the way of “meaning” that would have much importance to any one outside graduate school. It’s the restatements for popular consumption that transform the arcane into the ideological. Quoting investopedia’s definition of EMH,

    An investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

    This, of course, is untenable stupidity.

    But, “refuting” this stupidity with the examples of Keynes or Buffet does not mean that the hypothesis of financial market informational efficiency is rejected. It is the ideological (mis)statement, which is wrong. In fact, null hypotheses formulated in accord with the Fama’s EMH analysis, have been rejected in financial markets research; fairly simplistic value-investing rules formulated using the commercially distributed Value-Line dataset seem capable of “beating the market”. Moreover, it takes only a few moments thought to realize that market makers have to be making money in financial markets, or they would not persist. When one says, that no one can beat the market, presumably that means no one can beat the market at the margin, not infra-marginally; some of the money demand for financial securities will be diverted into research, depressing the overall money demand for financial securities (and by usual rough extension, prices overall, of financial securities), to the point where marginal this equals marginal that and blah blah, and some kind of equilibrium governs (or fails to govern, as the case may be) just how much research (or fraud) is done versus how much money flows directly to bidding for (and against) financial securities.

    I thought PP was too simplistic, when suggesting that “beating the market” was the average investor beating himself. That’s not a sensible formulation, not least because it leaves out entirely the institutional structure of financial markets and the relationship of those markets to other structures of the economy.

    Whether market prices are “right” can matter a great deal. The housing bubble was a case of the price of houses deviating in a way that proved devastating. And, the ideology of market efficiency is deployed to obfuscate whether it is even sensible to recognize that a housing bubble occurred, and, not incidentally, was driven by financial institution malfeasance. The problem isn’t that economics studies price formation and mechanism design — would that economics did more of that and did it well! — the problem is that the neoliberal and conservative libertarian ideologies that claim to be derived from economics promote stupidity and learned helplessness, as a way of neutralizing articulation of the public interest and the policymaking of the state. The EMH is trotted out to confuse discussion of whether particular markets structures and policies are producing correct or “efficient” prices.

    Anyway, sorry to come down so hard on this particular post. I generally enjoy and often learn from PP’s posts, but I thought this one did not meet the usual standard.

    1. Jim Shannon

      ….”the problem is that the neoliberal and conservative libertarian ideologies that claim to be derived from economics promote stupidity and learned helplessness,”….
      Stupidity and helplessness is ingrained into our culture by an economicl system designed to serve the greed of the Few!
      The Public Policy of this Republic, is one which rewards the greedy and the corrupt. The TAX CODE stands as a continuing proof to that Maxim. The TAX CODE is the problem and the stipid and helpless – clueless. Money rules this Government as the stupid and the helpless build wealth for the Monied Elite, who are content to cause a scourched Earth way before they will ever ALLOW the Stupid and the Helpless a seat at their table!

  17. James Cole

    Very correct, but it’s so much worse than what you identify. The EMH-as-ideology is akin to looking at a still photograph of Grand Central Station at rush hour and concluding that everyone in the photo has arrived at their destination because the train schedule is available.

  18. Eric L. Prentis

    Empirical evidence published in two academic journals scientifically proves the Efficient Market Hypothesis (EMH) is completely wrong.

    Prentis, Eric L. (2011). Evidence on a New Stock Trading Rule that Produces Higher Returns with Lower Risk. International Journal of Economics and Finance, Vol. 3, No. 1, 92-104.

    Prentis, Eric L. (2012). Early Evidence on US Stock Market Efficiency: “Market vs. State” Debate and Deregulation Implications. Economics and Finance Review, Vol. 2, No. 8, 23-34.

    Fama’s EMH Nobel Prize is payback for a “misinformation job well done.”

  19. gordon

    In the US, lots of people regularly go to church. This explains why there is no crime or violence or fraud or racism or warmongering.

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