Efficient market theory; Total junk still being taught to people?

[buzzy2]

Quote from vladiator:

Pick up an article by Litzenberger and try plowing through it and then saying finance is not science. give me a break. The truth is what you are taught in undergrad courses may not resemble science at all. Just like what you learn in the Physics 101 is very far from what the real science of physics is about. Some successful academics DO indeed have plenty of real world experience.

C'mon let's be realist let's not glorify the academic lifestyle. They are paid to sit everyday through seminars so boring they would drive me to suicide. They play their vicious politics for what? for getting and office here and not there? to get a position in committee X and not Y? Normal people don't care about those things... Also they give themselves importance because their name appear in BS journals? All this while doing "science" so pathetic they make true scientists cry... and while kissing rich guys' behinds to get their precious puppet positions in company boards and fund brochures.. to get consulting/litigation little jobs... or just good old cash they call "endowed professorships", "university endowment" etc etc.
Sorry but my main objective in life is freedom of other people's BS. Also I have a physiological flaw: my head hurts when I listen to BS, that's why I never could be an academic. And.. to get the free lifestyle I want I don't need a gazillion dollars, just a few million... anything else is just icing on the cake. In the great scheme of things I am nothing, that's true. But... is anybody?
Oh yeah I remember since Marx economists think they are the driving forces in history... right...
Also it is laughable how economists think they are geniuses with their formula-ridden papers, but first) most of the mathematical stuff in economics is just copy from physics and math stuff, and second) like darkhorse said they work with flawed premises and approches, so no amount of "mathematical" lipstick is gonna make this pig look good.
And finally you ridicule daytraders with their "one indicator T/A". You have no idea of the sophisticated math and software some short term traders are using to extract money from the market... That's why economists are the most ignorant of the lot... because they think they know everything.

 

[DT-waw]

First of all, look at Efficient Market's conditions:
1] infinite number of traders
2] single trader's orders don't have any influence on price (so, the market has infinite volume)
3] every trader has the same investment time horizon, risk tolerance
4] there are no transaction and news costs
5] every trader sees the same information in the same time and reacts to the news in the same way

These conditions cannot be met in the real world. Yes, it is just a "Theory" and nothing more

 

[darkhorse]

In addition to the good points brought up, I would like to add this question to the list:

What about the fact that there are very large players in the markets who have no vested interest in price discovery whatsoever?

Efficient markets theory not only assumes that all research is of unvarying quality (impossible and undefinable in the first place), it assumes that all players have an interest in valuing issues correctly- getting the price right.

Well, it seems fairly obvious there are plenty of large players who don't give a damn about valuing stocks correctly. Mutual funds aren't interested in finding the true value of the stocks they buy, they are interested in seeing them go up, especially near the end of the quarter or the fiscal year. Investment banks aren't interested in seeing their clients' issues valued correctly, they are interested in seeing them go through the roof. And there probably isn't a CEO alive who wouldn't be happy to see their stock 30% higher and would be happy to try and justify why it should be there.

When the big players (institutionals and mutual funds) have a strong financial incentive to play games with the little people's money (the public), and the public is either too dumb to know what's going on or happily approving of the scheme in the first place, the result is that rational price discovery is hardly even a major consideration in the first place.

 

[Madison]

Quote from darkhorse:

Efficient markets theory not only assumes that all research is of unvarying quality (impossible and undefinable in the first place), it assumes that all players have an interest in valuing issues correctly- getting the price right.

That is an excellent point - and you could add 'speculators' to that list as well. Volume attributable to day and swingtraders is largely based on the actions of other participants, with the composition of the security being secondary - I don't know the percentages, but I'd guess that a significant number of intraday swings are based only remotely on the enterprise value underlying the security.

 

[aphexcoil]

Market theory has always captivated me. As far as I can tell, markets are inefficiently efficient or randomly random, etc. There are periods of trends that take place.

I've gone over a lot of the math -- some too complex for me to grasp.

I am going to New Jersey with my best friend sometime in the next couple of months to visit someone by the name of John Nash. He went to Princeton and came up with "game theory." (My best friend's family knows him well).

I asked if I could come up to meet him and get his views on some questions I have.

I'll share my meeting with him with all of you (Probably be after Christmas -- if he's still kicking).

 

[aphexcoil]

Quote from Traden4Alpha:

Two economists are walking down the sidewalk when they spot a $100 bill on the ground. One economist starts to pick-up the money when the other economist says, "Don't bother, because its not real. If it was real, someone else would have picked it up already."

That's EMH for you -- don't bother looking for profits in the market because if there were profits there, someone would have gotten them already.


EMH contains two key flaws, the first is theoretical and the second is methodological.

We're all just happy little rational profit maximizers. NOT! The core flaw in the theory behind EMH is that everyone is rational and everyone is trying to maximize profits from the market. Yet, as the postings on ET prove, many of us are NOT rational at all. We all make trading decisions based on psychological factors that often drive us farther from our reputed goal of making profits (according to EMH, there's no such thing as scared money). Nor are many of us even profit maximizers. Many traders prefer winning trades to aggregate profits. Institutional traders want to keep their jobs and thus seek "safe" choices over profit-maximizing choices. That we are not rational and that we don't all share the same profit-maximizing goal knocks out two legs of the EMH stool.

Zero correlation = zero predictability? WRONG! The methodologies of much of the EMH literature depend on linear correlation. But that presumes that the only possible relationship between prices is linear. Yet, there are deterministic relationships with zero correlation. A good example is the logistic map where the next value of X is determined by the function Xnext = c*Xprior*(1-Xprior). When c = 4 and the X's are between 0 and 1, the result of running this equation is a time series of values with zero autocorrelation, but 100% predictability from value to value. The point is that nonlinear relationship between future and past prices would be totally missed by a correlation study.


BTW, I think that joke is a commentary on both economists and traders. That the economist disbelieves in the $100 bill shows the folly of EMH theory. That traders believe in finding $100 bills shows their greed and naivete. The profits are there, but they are not as plentiful as many would hope.


Wishing efficient exploitation of inefficiencies to all,
Traden4Alpha

I would have to say the markets are more efficient as the ratio of what you know compared to what everyone else knows approaches one.

Was the market efficient for those select few who knew THC was going to come out with bad news? Obviously, from their perspective, it could be argued that the market was in a very inefficient position to their view of the market (which was substantially more than the average Joe).

The only clue that others had were two strong red candles with increasing volume, but a lot of people were:

a) Buying the dip (Oh look, THC is down! What a bargain)
b) Selling with the thought (Hmm, something is technically wrong here, volatility just spiked, volume is up and prices are falling)

There could be countless scenerios where group A is correct and group B is correct. However, group C (the insiders) are the only ones who know the entire story behind those two red candles before news hit.

Also, the market is EXTREMELY efficient to the new trader. As a trader gets more experienced, the market becomes less efficient.

Trying to call the market efficient or inefficient is like saying, "This painting is very depressing." Yes, to some the painting is depressing, but to others it may be happy. Likewise, people with more knowledge will be in a better position to exploit the inefficiency of the market. That inefficiency comes from knowledge.

We could say that perfect efficiency is 1. Perfect inefficiency is 0. Someone who is just randomly trading will meet perfect efficiency. Someone who is experienced, has inside knowledge or is in a position located outside the masses enjoys a number less than 1.0.

Trying to determine if markets are efficient or inefficient is pointless. The real truth is that the market is both, based on the reality of the observer.

 

[vladiator]

Quote from DT-waw:



Please explain, what does it mean "appropriately"? I've also lived in socialism (Poland). Hmmm now it's a country with 50% socialism and 50% capitalism... I can tell you what many of us already know: capitalism is the best system created so far. Because the stronger, more intelligent, effective will always win, and the weaker, less intelligent, less-effective will always have to lose. That's how the nature (and real markets) work and you can't cheat the Nature.

Again, trying not to reignite the ardent debate that took place in another thread on the issue, I agree that capitalism does a better job of giving incentives for people to do their best. However, it sucks at providing the so-called "public goods" b/c of the free-rider problem noone would pay for them. Capitalism is a very viable system in practice b/c it's perfectly alligned with the greedy human nature, although one has to make sure the appropirate laws are in place to avoid extremes. But a socialist system with decent entrepreneurial incentives is a more equitable and much "happier to live in" set up. I can relate to your experience in Poland. Now you have close to a perfect mix of the best of both worlds. What is going on on the terrain of the former USSR is very close to the capitalism in its purest and most unrestricted sense, money buys anything and there are very few (if any) laws that can not be bent for those with the wherewithall. Hardly any (read almost no) social protection for the elderly etc. The misconception that people have when they think of capitalism is that they think it's what the US has and that just HAS TO BE THE BEST, b/c the US RULES! The truth is had it had a pure capilalist set up, with absolutely no socialism added to it, people would opine very differently. My guess is that in the US it's an about 85% to 15% mix of elements of capitalism vs. socialism. All I'm saying is that a system with much more of the latter would still thrive b/c of the stimuli to do your very best and reap rewards from it, although the society would benefit tremendously from the improved provision of public goods and the like.

 

[vladiator]

Quote from Babak:

There is a fantastic book by Shefrin called "Beyond Greed and Fear". He's a behavioural finance guy and he takes delight in sparring with Fama and his groupies.

In that book you'll find a bakers dozen of "irregularities" that the Chicago gang just can't explain.

It is obvious that they have been on the defensive ever since they put out the theory. It has been assailed from every side with studies that punch holes in it wide enough for a freight train to pass through.

The EMT reminds me of Hume's black swan story. With apologies to Hume, one could paraphrase:

No matter how much "efficiency" you see, it will not prove that the market is "efficient". Yet, spot one "inefficiency" and you can no longer call it an "efficient" market.

Fascinating debate! I hope that it continues and that people continue to have differing opinions. That is what makes it so exciting.

A few points in the previous dialogue that I wanted to comment on:

-there is no Nobel Prize for Economics (not technically anyway). What they give out was never part of that great man's Will and Testament. It was added on later.

-the greatest proponents and champions of the EMT theory were the 'brains' behind LTCM. The irony is somehow lost on people that the same persons who gained fame and fortune for "proving" that theory, later went on to found a hedge fund that was based on exactly the actionable "inefficiencies" of the market!!

To the very bitter end they fought (and still do to this day!) that their actions (based on their theories) were "correct" and that the market had gone bonkers....therefore it was not their fault!!

To this day, they view the collapse of LTCM and the dangerous precipice it nudge us close to, to be the fault of everyone but them!!

Tis true that intelligence and common sense rarely are given to the same persons.

Yep, I agree, "Beyond greed and fear" is worth reading. We had that book as one of the assigned readings in one of our seminars a year or so ago.
The paper I posted a few posts earlier attempts to address those irregularities and as I remember (I read the later published version, so the working paper I posted may not have all the details, but for those interested, I think it's in the Journal of Finance 1999) the key point it gives (and one that I happen to agree with) is that there is no consistent theory/model that systematically explains the timeseries and cross-sectional variabiltiy of stock returns better than EMH. It's very easy to find a small "pocket of inefficency" with enough data snooping. Some of those are indeed little arb opportunities and will go away as you trade on them. Many are simply the results of data mining. But there is NO alternative offered to EMH by those who throw spears at it. Is it some phsychological overreaction/underreaction model suggested by Shefrin and those he cites?
Would be nice except that it doesn't seem to be consistent across samples/time periods etc. Very often those who public a paper on some overreaction anomaly publish another one plugging underreaction in very similar circumstances. In most cases one can't really make any money on those even if the effects are truly there b/c of the price pressure. Much more often they are just artifacts of data snooping and the under/overreactions etc are just randomly scattered across studies as they would be under EMH.
I like your analogy b/c that's exactly the tone of my numerous opponents on this board and summarizes it perfectly. It seems that for most people just b/c there is a tiny fleeting arb opportunity here and there means that the markets are not efficient. That's not what EMH implies, it implies that those arb opportunities will not be there for long and will certainly not be very salient and obvious. I think this statement is very true in light of the fact that most on this board are not millionaires b/c of their trading. In fact, it might be a somewhat biased sample b/c those who really suck get washed out and those that become outliers remain. I agree that in many cases those outliers are indeed trading based on true arb opportunities and are perfect examples of exactly what makes this such an efficient market. But given enough of those trying, it's only a statistical fact that many may be simply lucky.
The LTCM example is also a very relevant one And yes, indeed they were right when everyone was wrong. It's just that sometimes it take a looooong time for those who are wrong to realize it and the LTCM guys didn't expect such a delay.
It's just as if you predicted that the market was overprice half way into the bubble and started shorting. Well, you would have been right in light of todays index levels, but whether you would weather the time it took is a different question

 

[daniel_m]

Quote from DT-waw:


These conditions cannot be met in the real world. Yes, it is just a "Theory" and nothing more

well, the whole of science condenses to "just theory". of course, it's still proven itself extremely capable of explaining reality.

efficient markets, imo, barely makes the grade as even a decent hypthothesis.. and if the halls of academia were to be completely intellectually honest (buzzy and others have given good reasons as to why they are not), we'd have thrown out EMT a long time ago... or, since it's undergone so many mutations, at least had the guts to call it something else... at the very least, i think it would only be proper to do away with its most glaringly stupid conclusion - that the market cannot possibly be beaten..
then again, with the desperation of the social sciences to be considered and accepted as ACTUAL science, i wouldn't expect that to happen any time soon..

also, could someone tell me what it actually means to "beat the market"... since it gets talked about so much i think it would only proper to actually get a definition of what standard we are comparing our efforts to..

and vlad, you're always good for a laugh

 

[daniel_m]

Quote from vladiator:



The LTCM example is also a very relevant one And yes, indeed they were right when everyone was wrong. It's just that sometimes it take a looooong time for those who are wrong to realize it and the LTCM guys didn't expect such a delay.
It's just as if you predicted that the market was overprice half way into the bubble and started shorting. Well, you would have been right in light of todays index levels, but whether you would weather the time it took is a different question

as i said, you're always good for a laugh.

i'm sure you could write a book defending their actions...
most traders would just call it for what it really is - crap trading