Tag Archive for 'Behavioural finance'

Defending the EMH

Tim Harford has gone in to bat for the Efficient Market Hypothesis (EMH).  As Tim says, somebody has to.

Sort-of-officially, there are three versions of the EMH:

  • The strong version says that the market-determined price is always “correct”, fully reflecting all public and private information available to everybody, everywhere.
  • The semi-strong version says that the price incorporates all public information, past and present, but that inside information or innovative analysis may produce a valuation that differs from that price.
  • The weak version says that the price incorporates, at the least, all public information revealed in the past, so that looking at past information cannot allow you to predict the future price.

I would add a fourth version:

  • A very-weak version, saying that even if the future path of prices is somewhat predictable from past and present public information, you can’t beat the market on average without some sort of private advantage such as inside information or sufficient size as to allow market-moving trades.

    For example, you might be able to see that there’s a bubble and reasonably predict that prices will fall, but that doesn’t create an opportunity for market-beating profits on average, because you cannot know how long it will be before the bubble bursts and, to regurgitate John M. Keynes, the market can remain irrational longer than you can remain solvent.

I think that almost every economist and financial analyst under the sun would agree that the strong version is not true, or very rarely true.  There’s some evidence for the semi-strong or weak versions in some markets, at least most of the time, although behavioural finance has pretty clearly shown how they can fail.  The very-weak version, I contend, is probably close to always true for any sufficiently liquid market.

But looking for concrete evidence one way or another, while crucially important, is not the end of it.  There are, more broadly, the questions of (a) how closely each version of the EMH approximates reality; and (b) how costly a deviation of reality from the EMH would be for somebody using the EMH as their guide.

The answer to (a) is that the deviation of reality from the EMH can be economically significant over short time frames (up to days) for the weak forms of the EMH and over extremely long time frames (up to years) for the strong versions.

The answer to (b), however, depends on who is doing the asking and which version of the EMH is relevant for them.  For retail investors (i.e. you and me, for whom the appropriate form is the very-weak version) and indeed, for most businesses, the answer to (b) is “not really much at all”.  This is why Tim Harford finishes his piece with this:

I remain convinced that the efficient markets hypothesis should be a lodestar for ordinary investors. It suggests the following strategy: choose a range of shares or low-cost index trackers and invest in them gradually without trying to be too clever.

For regulators of the Too-Big-To-Fail financial players, of course, the answer to (b) is “the cost increases exponentially with the deviation”.

The failure of regulators, therefore, was a combination of treating the answer to (a) for the weak versions as applying to the strong versions as well; and of acting as though the answer to (b) was the same for everybody.  Tim quotes Matthew Bishop — co-author with Michael Green of “The Road from Ruin” and New York Bureau Chief of The Economist — as arguing that this failure helped fuel the financial crisis for three reasons:

First, it seduced Alan Greenspan into believing either that bubbles never happened, or that if they did there was no hope that the Federal Reserve could spot them and intervene. Second, the EMH motivated “mark-to-market” accounting rules, which put banks in an impossible situation when prices for their assets evaporated. Third, the EMH encouraged the view that executives could not manipulate the share prices of their companies, so it was perfectly reasonable to use stock options for executive pay.

I agree with all of those, but remain wary about stepping away from mark-to-market.

A question for behavioural economists

How true is the old adage “easy come, easy go”?  More formally, is it fair to suggest that an individual’s marginal propensity to consume (MPC) — the share of an extra dollar of income that they would spend on consumption rather than save — depends on the origin of the income?  The traditional wisdom would suggest that:

MPC (fortuitous income) > MPC (hard-earned income)

Have there been any studies on this?  If so, have there been any studies that apply the results to the evolution of US inequality in income and consumption?

Conspiracy theories and the current market turmoil

A friend pointed me to this conspiracy theory video. I’ve not watched more than 30 seconds of this particular video, but according to discussion on the RANDI forums, I understand that it splices footage directly from a number of other conspiracy theory films into one, with all the greatest hits of the anti-establishment anarchist left being given a run (christians and/or jews are evil and secretly rule the world, 9/11 was a government inside job, the entire global banking system is a sham and run by bad people, etc).

Of more interest to me is this question, put to me by my friend:

Why are more and more of these conspiracy theories coming out in video format only, with no transcriptions?

Perhaps it’s to appeal to a wider audience (i.e. more people are willing to watch a movie than read the equivalent text). Perhaps it’s because a movie can more readily achieve an intense, even emotional, impact than abstract text. Perhaps it’s just another example of market demand and supply …

The real (as in true) explanations for what goes on tend to be considerably more complex and almost infinitely more tedious than those offered by conspiracy theorists. People seem to want answers, but aren’t willing to accept that they might be anything other than simple and exciting. Maybe that’s a result of today’s media culture of soundbite-driven news and action movies, but maybe it’s just an unfortunate consequence of otherwise rational ignorance. You can’t be an expert in everything (strictly speaking, it’s too costly), so you don’t waste your time trying and instead trust the summaries given by people you take to be experts.

As an example of the demand for simplified summaries, consider the recent turmoil on the world’s credit- and stock-markets. I have spoken to several people about the happenings and most of them aren’t the least bit interested in understanding the details of what’s going on. Instead, they only want to know if (a) the world is going to end (i.e. they’re going to lose their job or their pension savings are going to collapse) or (b) if it’s all been caused by evil, money-grubbing people deliberately destabilising the world for their private profit.

By my thinking, to really understand the current turmoil (I still refuse to call it a crisis), you need to understand the basics of:

  • How bonds work
  • The difference between long-term and short-term bonds
  • The difference between government and commercial securities
  • The fact that central banks announce a target interest rate rather than fixing it by fiat
  • Reserve requirements
  • Overnight inter-bank lending
  • How banks view loans to consumers (i.e. as assets)
  • Structured finance in general
  • CDOs in particular
  • Derivatives
  • Hedging and hedge funds
  • The difference between credit markets, stock markets and foreign exchange markets and how movements in each might affect the others
  • The carry trade

And that’s before you start considering the psychology of the people involved and all the resulting work in behavioural finance. Unless you’re seriously (and usually, professionally) interested in investment, finance or economics, why would you care about all of those details? You wouldn’t … you just want to know if the world is going to end and if there’s somebody to blame.

On the supply side of these nuggets of information, you have … well, you’re looking at one. Commentators, both professional (in the mainstream media) and self-appointed (in your local pub and all over the internet) are competing to convince you that they are experts in the topic at hand and having managed that, to provide you with their summarised opinions.

Suppose, however, that for some reason you can’t properly identify who is a real expert or you have some reason to distrust the experts you can identify. In that case, you’re left taking in the simplified views of non-expert subject-matter aficionados, of which a small but statistically-significant fraction are going to be conspiracy theorists. Insofar as they want to expand their customer base, conspiracy theorists (who, to be frank, are often less troubled by the truth than they are with attracting an audience) will experiment with their provision of service to best meet the demand for simple and exciting explanations. Thus, we have movies with no (tedious) transcripts.