http://www.themoneyillusion.com/?p=11277
For Sumner's latest EMH apologetics see here
http://diaryofarepublicanhater.blogspot.com/2013/02/sumner-emh-now-proven.html
Yesterday Woj alerted me to a piece by Noah Smith in defense of EMH. That's a little more notable-as it doesn't happen every day; Sumner, of course, more or less does defend EMH everyday, or a lot anyway.
Noah explains that EMH at one moment will be right and at another not so much:
"The "efficient" actually just refers to information-processing efficiency. What that basically means is that if there's some piece of information out there - some fact about a company's balance sheets, or some pattern in past prices, etc. - the market price should reflect that piece of information. That's what "efficient" means here."
"But exactly how should prices reflect information? Here's the bigger
problem with the term "EMH" (the "sloppy science" part) - it's not really a
hypothesis. How prices reflect information will always depend on people's
preferences. In finance, preferences include preferences about risk. So without
a measure of risk, it's impossible to scientifically test whether or not prices
incorporate information. To be a real hypothesis, the EMH needs to be paired
with a specification of risk (or, more generally, a hypothesis about people's
preferences with respect to uncertainty and time, and a hypothesis about the
sources of risk). And since there are many possible such specifications, there
isn't just one "EMH"...there are infinite."
"To complicate things, "the EMH" says nothing about how long it takes for
the market to process information. So even if an EMH happens to be true at one
frequency (say, daily), it might not be true at the 1-second frequency.
"OK, so is even one of these EMHs true, at some frequency? We can do
statistical tests, but we'll never really know. First of all, our tests are all
pretty weak. But more importantly, conditions may change! An EMH might be true
for a while, and we might conclude it's true, and then things might change and
for one or two years it might stop being true, and then we'd do some more
statistical tests and say "Oh wait, I guess it's not true after all!", and then
it might go right back to being true! We generally assume the laws of physics
don't change from year to year, but it's easy to imagine that the "laws" of
finance aren't as immutable. What if the market is "efficient" 99% of the time,
and the rest of the time there's a catastrophic bubble?"
"And to top it all off, theory
says that the strong form of the EMH can't even be true.
"So "the EMH" is very limited as a scientific hypothesis or physics-like law
of nature. And I think that ever since many of these points were pointed out (I
think by Andrew Lo, though someone else may have preceded him), financial
economists have stopped talking about "the EMH" as such, except in a vague
hand-wavey way during informal discussions. Sloppiness has been much
reduced.
At this point, Noah realizes he may be losing us. After all it hardly seems that something this speculative is vital that we believe in.
"But I do seem to recall that the title of this post was "In defense of the
EMH". So I had better get around to defending it! What I want to defend is the
idea behind the EMH. Even if the data rejected every single EMH, the idea
would still be incredibly useful for the average person."
"Let's call this idea the Random Markets Idea, or RMI."
"The simplest form of the RMI was stated by Paul Samuelson in 1965:
"Properly anticipated prices fluctuate randomly." Basically, if it was pretty
easy to see where prices were headed, a lot of people would see it, and try to
make free money by trading on it. Since people in the finance industry are doing
a lot of work - watching the news like a hawk, doing constant analysis of
changing numbers - chances are that the price change will happen so fast that
you won't have time to get in on the action. So from the perspective of any of
us who doesn't have a supercomputer in his head, prices movements must be
unpredictable and surprising. They must seem random."
"That's it. That's the RMI. Note that this is very different than saying "On
average, people don't beat the market average." This is more than that. This is
saying that even if you manage to beat the market average for a year or
two years or even ten years, you shouldn't expect to be able to repeat your
performance next year."
What this defense seems to amount to is that the EMH helps us realize we can't beat the market via the RMI. Do we really need it for this though? The trouble is as well is there are so many other uses that EMH is put to besides this? He mentions Behavioural Finance which doesn't agree with RMI but also thinks you aren't likely to beat the market year after year.
I'm not clear if we need EMH or even RMI to be sufficiently cautious of the market. We can probably come to the punchline that you should invest in some prudent ETFs or funds without EMH.
Whether you can or not, what about all the ill uses that EMH is put to? Noah's focus is simply that EMH gives us good stock market advice. What about all the ill uses a Scott Sumner puts it to? As the reader Tom Brown suggested Sumner is not above using EMH to prove that
A). Bubbles don't matter.
B). Assuming they really exist.
C). And they probably don't.
What are the implications of EMH for Macro? Many of them are not too good.
P.S. On the level of investment advice, it's obviously prudent and may well be true. I beat the market in 2008 and wasn't able to do it again. Still I think this is partly because it's a different kind of market that you have to approach differently than the one we had during the Lehman's Brother collapse. During that time there was a lot of cash to be made shorting the bank and commodity stocks.
Since April 2009 it's actually been via buying and holding. I kind of agree with Noah's commentator Eric L.
"And as a result they lose money, relative to the wise folks who just stick their money in a low-cost diversified portfolio and watch it grow. As for institutional investors - mutual fund managers and pension fund managers - we don't know as much about what they do, but we do know that very few of them manage to consistently beat the market, year after year (and most don't beat the market at all)."
"Next you're going to tell us most of our children aren't above average..."
"I agree with all this as investment advice for me personally, but obviously someone out there has to decide based on their information about the market what the price of AAPL ought to be and make trading decisions accordingly if there is to be any information whatsoever incorporated into its price. What fraction of the market has to actually make informed decisions to make it work properly while the rest of us walk around blindfolded, confident that if there were any hundred dollar bills on the sidewalk someone would have picked them up by now?"
What this defense seems to amount to is that the EMH helps us realize we can't beat the market via the RMI. Do we really need it for this though? The trouble is as well is there are so many other uses that EMH is put to besides this? He mentions Behavioural Finance which doesn't agree with RMI but also thinks you aren't likely to beat the market year after year.
I'm not clear if we need EMH or even RMI to be sufficiently cautious of the market. We can probably come to the punchline that you should invest in some prudent ETFs or funds without EMH.
Whether you can or not, what about all the ill uses that EMH is put to? Noah's focus is simply that EMH gives us good stock market advice. What about all the ill uses a Scott Sumner puts it to? As the reader Tom Brown suggested Sumner is not above using EMH to prove that
A). Bubbles don't matter.
B). Assuming they really exist.
C). And they probably don't.
What are the implications of EMH for Macro? Many of them are not too good.
P.S. On the level of investment advice, it's obviously prudent and may well be true. I beat the market in 2008 and wasn't able to do it again. Still I think this is partly because it's a different kind of market that you have to approach differently than the one we had during the Lehman's Brother collapse. During that time there was a lot of cash to be made shorting the bank and commodity stocks.
Since April 2009 it's actually been via buying and holding. I kind of agree with Noah's commentator Eric L.
"And as a result they lose money, relative to the wise folks who just stick their money in a low-cost diversified portfolio and watch it grow. As for institutional investors - mutual fund managers and pension fund managers - we don't know as much about what they do, but we do know that very few of them manage to consistently beat the market, year after year (and most don't beat the market at all)."
"Next you're going to tell us most of our children aren't above average..."
"I agree with all this as investment advice for me personally, but obviously someone out there has to decide based on their information about the market what the price of AAPL ought to be and make trading decisions accordingly if there is to be any information whatsoever incorporated into its price. What fraction of the market has to actually make informed decisions to make it work properly while the rest of us walk around blindfolded, confident that if there were any hundred dollar bills on the sidewalk someone would have picked them up by now?"
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