November 12, 2010
Usefulness of the Efficient Markets Hypothesis
Posted by Jeff Schwartz

The efficient markets hypothesis has come under heavy attack in the last couple of years.  For defenders of EMH, the fallback position appears to be that, even though the theory may not be technically correct, it is the best approximation of market behavior.  The implication is, therefore, that it is still a useful descriptive tool.

I’m not sure this position is sustainable, however.  EMH says that stock prices are right—not in some absolute metaphysical sense, but at least in that they represent society’s best guess based on available information.  Behavioral finance scholars point out, however, that there are ubiquitous limits to arbitrage that stand in the way of the market reaching this happy equilibrium. 

We can’t, therefore, merely look at a stock’s price and assume it is accurate.  What behavioral finance tells us is that what we see is the result of the interaction of a complex set of factors.  A better description of market prices, therefore, may be that they are inaccurate, with the extent of the inaccuracy (anywhere from mild to wild) being a function of how constraints to arbitrage are interacting with and influencing market trading at any given time.  

On a related point, even if EMH were correct, I think its usefulness can be questioned.  EMH claims that stock prices represent society’s best guess based on available information.  But what does that tell us?  Nassim Taleb’s work would suggest not very much.  Today’s stock prices are based on predictions of future events, specifically how future events will impact corporate profits and dividends.  But if the future is dictated by “black swans” that are unpredictable a priori, then stock prices can only be accurate in an impoverished sense of the word.  And even if we are not fully convinced by the black-swan metaphor, it still stands to reason that even if stock prices were rational, they would merely represent guesses regarding a cloudy future. 

Most broadly, what all of this suggests is that we should adopt a more modest and skeptical view of market prices, rather than casually assuming market perfectionism.

Economics, Finance, Investing, Securities | Bookmark

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