Efficient markets by any other name would smell as sweet

Via the Economist, a nice reminder that it doesn’t make a lot of sense to try and beat the market yourself, and even less sense to pay somebody else to do it (and it’ll cost you dearly). The market’s efficient – it’ll efficiently punish you for trying. I know, somewhat of an old story; you won’t win any shiny gold coins with that one anymore. Yet, people like to tell tales of those exceptional geniuses who defiantly manage to outperform the S&P500 in the epic battle that is the financial market.

On the other hand, you also won’t get any medals anymore for pointing out that many investors seem to behave rather irrationally (for example, they’re willing to pay somebody else to beat the market). Yet we think of the sum total of the chaotic, unpredictable, occasionally (asset) bubbly behavior of those people as a – maybe the one true – efficient market. In finance, it seems to me, familiar words have peculiar meanings.

Beasts of the Stubborn Wilds

Somewhere out there among the canid natives to the wilderness and remote areas of North AmericaEurasia, and North Africa of Wall Street, the mythical market beaters roam. Those who know where the ‘value stocks’ are at. Who have stubbornly resisted efficient market hypotheses. That they exists at all may seem odd for a second, given that I specifically stressed that active trading isn’t a very lucrative prospect. Then, you’ll realize that given the number of people who want to ascend to the ranks of those fabled few, it’s pretty obvious that some of them are gonna make it. It’s just that the overwhelming majority won’t.

There’s another problem: nobody knows who they are! You can’t look at past performance, because that’s not an indicator of future performance. More importantly, it’s no good if you know that somebody outperformed the index for the last ten years. You wanna know that they’re going to do well over the next few years! Unless you found a golden tablet inscribed with the names of all the great hedge fund managers that were, are, and will be, you’re screwed.

Overall, the whole idea of active investing doesn’t seem like a terribly efficient deal. But if people just like playing Leo DeCaprio, why not let them? So long as the underlying market is efficient, we’re golden, right?

The boy who cried grossly overvalued

Because stock returns move around so wildly (while things like GDP usually rise over time), it might seem that the process creating those returns can’t be terribly efficient. They don’t seem to follow a pattern. Paul Samuelson of course resolved that puzzle, proving that prices that incorporate all available information at any point in time will seem to fluctuate randomly. Samuelson was a really smart guy though. Which is why, in that same paper, he also said:

One should not read too much into the established theorem. […] It does not say that speculation […] or that randomness of prices is a good thing. It does not prove that anyone who makes money in speculation […] has accomplished something good for society. All or none of these may be true, but that would require a different investigation.

That part of the paper seems to get less press. Fama and Shiller of course both tried to deliver that ‘different investigation’. Are stock movements unpredictable because they instantly soak up new information? Or do they seem crazy because investing fads and bubbles are simply crazy, crazy things?

I won’t try to resolve that age-old debate here. Although I will say that it doesn’t seem overwhelmingly rational (or even smart) to buy a bunch of dot.com stocks, then have someone tell you that that’s crazy (“those companies are grossly overvalued!”), and then go nuts with fire sales. Unless, of course, you only bought them because someone else (or possibly the same person, if your broker’s really good) told you that dot.com wasn’t crazy at all.

You can’t cheat an honest man with a dictionary

My point is this: how on earth did we ever decide to use the term efficiency in this context?! Of all the wonderful words we have at our disposal to describe what’s going on with stock returns, why did we choose one that makes absolutely no sense? Let me illustrate:


 noun \i-ˈfi-shən-sē\

: the ability to do something or produce something without wasting materials, time, or energy : the quality or degree of being efficient ( technical )

Does that really seem like the perfect description of financial markets, when all we can really say is that stock movements can’t be predicted based on their past values? You know, I don’t wanna go out on a limb here, but it has at times occurred to me that financial markets can, you know, occasionally, I guess, engage in activities that, on the surface, seem rather like a giant waste of materials, time and energy, with an absolute lack of the quality or degree of being efficient.

Here are a few alternatives that I propose to replace the term ‘efficient market hypothesis’ until we have determined which ‘different investigation’ was right:

  • unpredictable markets hypothesis
  • random stuff happens hypothesis
  • index funds rule (on average) hypothesis
  • ARIMA(0,1,0) hypothesis (that last one’s a little too nerdy to really catch on with Wall Street types I fear)

So please, take your pick. I’m also open to suggestions! But let’s find an expression that’s more accurate, and less of an abuse of the English language.

4 thoughts on “Efficient markets by any other name would smell as sweet

  1. mdbold

    A very nice look at the issues. I agree that most of your proposed names could be used to describe the stock market. But I don’t think that the dictionary definition of efficiency is what the efficient market people have in mind — it is more that the market responds to all available information. That still leaves room for waste, I think.

  2. wyna

    Nicely summarized post on ‘A Random Walk on Wall Street’ with very farcical ending haha. Although I am largely on side with what the post says, just to play the devil’s advocate, Warren Buffett did refute some of these claims that it is very not likely to have people who beat the market consistently all from the same town –referring to himself and his troops in a mighty quest to slay the market. I have he has some points that it is not completely by chance that disciples of Ben Graham were able to beat the market, but I thinks there are also selection bias in that he only hung out with people who did beat the market.

  3. agolicz

    Interesting post. I think there have been a few hypothesis that touch on the traits of randomness and unpredictability you mention, including the random walk and martingale hypotheses. Also, regarding the efficiency of the market to all available information, is it possible that the market accurately reflects all available information all the time, or is there a lag to how quickly information gets disseminated? I think Prof Kilian mentioned briefly how the market may be efficient over long periods of time (looking at annual or quarterly data) but that at shorter frequencies there may be lags (intra-day data). I’m definitely not an expert, and there seems to be a myriad of different theories out there, so I’m curious about which one(s) have the most validity.

  4. Emma Zhang

    Very smart points you made in the post. Yet I must say I am not completely agree with your point of discarding the word ‘efficient’ to describe financial market. I do agree that financial market utilize all the information available will appears to be moving randomly, but randomness does not mean wasting those information or time to respond to those information. On the contrary, it means that all participants in the market are responding too quickly and efficiently that when you look at the graph on a longer time horizon, say, a month, there seems to be no patterns to follow.

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