I have a recent business degree, but not finance or econ. In school we were strictly taught the market is efficient and I fully believed that. But I've seen online and discussed in person a (seemingly) growing idea that markets are not in fact efficient at all.
Are there any economists/finance people that can shed light on this? Are these new ideas gaining traction, or old ideas just sticking around?
In particular, the precondition that Adam Smith stated was that increasing production required linearly increased costs. However, this is frequently not the case (utilities, railroads, software, social media networks, etc.). Also, markets require a certain minimum number of producers (and consumers) in order to remain efficient. Consolidation can reduce the number of producers below the level that meets the precondition of efficiency, and then barriers to entry to prevent newcomers from joining the market.
As far as efficient market theory applied to the stock market, I've always thought that efficient market theory was trivially disprovable: did all companies in the US lose 20% of their value all at the same time this past Nov - Dec, in the same season that they are selling all their inventory during the holiday season? And then regain 10% of it all at the same time the next month? Did Apple lose 50% of its value from between July and December, despite the fact that its revenues, costs, dividends, assets, people-capital, know-how, brand, consumer sentiment, etc. remained roughly the same? Compare to, say, PG&E during the same period.
Everything then made sense. All the inconsistencies you hear about economics, with one camp saying one idea and another talking about something totally different, both passing it off as consensus, fit into place.
TLDR: Cassidy's book is in 2 parts. The first part, he constructs the classical/rational model of economics through intellectual history. The second part, he deconstructs, drawing from all the critiques of inefficiency, both behavioral and mathematical. (Some of the most fascinating aspects are the beautiful mathematical models that can't be solved). It's all well written prose, no need to have a pen and calculator to follow along.
The title is misleading IMHO, because it seems to be a populist polemical. It's not. It should be called something like "A Brief History of Economics", echoing Hawkin's Brief History of Time.
The idea that regulators have the ability to design, implement, and maintain laws that correct or protect from market failures without producing unintended consequences, perverse incentives, significant costs, or market distortions more severe than the original market failure was not sufficiently addressed, from what I remember. Despite their problems, markets tend to be dynamic, adaptive, and innovative, while regulations tend to be rigid, slow, and reactionary. I don't know what the answer to market failure is, but I found the book unsatisfactory in that regard.
He goes to GREAT lengths to talk about all of the potential pitfalls and problems with placing regulations on these industries. And he even gives many examples of times in the past where things did and did not work.
Sure, you can get a positive outcome from the wrong approach. But examples are probably the best thing we can look to...
1) Markets are efficient enough in that you generally don't see any real big arbitrage opportunities. Small ones will always be present, and as is often pointed out its not worth the big players time to search them out and capitalize.
A trader also sees this as evidenced by the fact that we are using more and more data and ever increasingly complicated math to eek out smaller and smaller chunks of alpha.
2) different people have different ideas as to what the correct price actually is.
Consider a company that is continually losing money.
- Fundamental analysts will value this as a poor company due to its future cash flows dwindling. They may consider this a short opportunity
- Merger Arb folks may bid up this up as a potential merger target thus raising the price.
- ETF's tracking an index just don't care, they'll buy the company in proportion to its index weight.
- Stat arb folks will be agnostic to price and only compare it to a peer that they feel it will trade in relation ship with, these people will be both long and short this company at different times, often unrelated to what its price currently is.
3) Physics often uses the simplifying assumption of no friction to make things easier. The efficient market hypothesis works under the assumption that everyone knows about news immediately and has time to react. Some investors react in micro seconds, some in weeks. Both affect the price
Efficient market theory is mostly used to justify deregulation, to protect the profits of the big players who can throw the most weight around.
Some economists support this (perhaps because their paychecks depend on it, or they were brainwashed at the University of Chicago where the movement was strongest). But I doubt most do, especially these days, so soon after the reminder of the Great Recesssion, 80 years after the Great Depression taught the initial lessons. But Keynes got boring for some I guess, and the allure of the "totally rational human" was clearly too great for some, and attractive to lobbyists.
https://www.nytimes.com/2009/09/06/magazine/06Economic-t.htm...
It seems such an obviously rhetorical (i.e. politically expedient, not fact-based) narrative intended to sell the idea that markets are the very best of all possible ways to organise everything - in spite of all the centuries of historical evidence that markets consistently run in an irrational bubble-driven boom-bust cycle with almost insanely destructive opportunity and recovery costs.
The logic is this: if this were not the case, then some of those very smart hedge fund people were take advantage of this strategy, making that strategy become the average that everyone wants to beat.
AFAIK, Keynes claimed that the market is more efficient than not. But he was decidedly not a believer of the efficient market hypothesis! Further, he was mostly concerned with money supply and risk-free government bonds.
Sometime between the 60s and the 80s, Keynes got associated with Supply-Side Economics and Laissez Faires (which from my understanding Keynes was completely against).
Also, when Keynes was writing -- FIRE (Finance, Insurance, and Real Estate) amounted to about 5% of the U.S. economy. Now it amounts to more than 30%. So, ideas that weren't concerned with those markets probably need to be concerned with them now.
The Efficient Market Hypothesis states that every asset is fairly priced, because anything that CAN be known about it has been ALREADY factored into the calculation of price.
That's like walking down the street, seeing $20 and thinking, "Nah, if there was money on the ground someone would have picked it up ALREADY".
Markets trend towards Efficiency, they are not in themselves efficient
In other words, the EMH does not preclude $20 bills from lying on the street. It does imply that, in an idealized market which is informationally efficient, you cannot predict where people are dropping $20 bills around the city.
Your example is one of the most common mis-analogies of what the EMH states. But in point of fact, if the EMH precluded any better-than-market returns, it would not be possible to have a market since you'd have no risk or volatility.
Another argument against EMH is to assume it is true. Market wages for quants and hedge fund employees would reflect their true value. But wages for quants are a lot higher than the cost of using a random number generator. If all trading success can be attributed to luck or chance, it would make no economic sense to hire expensive quants, hence EMH being true leads to a contradiction.
I do believe in a no free lunch theorem for market pricing. Averaged over all traders and all stocks and all strategies, there is no perfect approach that beats the market consistently. But that is of little practical value (in inference and search the no free lunch holds, but we can still use prior information to limit search ranges, focus on the profitable markets, and use approaches that worked on similar problems).
And then on the question. Perfect information is false and there are degrees in the definition of how efficient markets are, with the most common one approximating 'somewhat' on the not too short timescale. Mileage varies between commodities, stocks, your staple teaching example of the market for used cars (lemons) going towards the more micro models with network effects etc.
Institutional economics will teach you that no market functions without surrounding institutional arrangements and that there is some relationship between the nature of the product and the optimal 'institutional burden' (my words). Mechanism design is the subject where they try to design optimally structured markets.
Economics is awesome and anyone teaching only perfect information even to undergrads or business students should be fired. Ceterum censeo
It's mostly ideology with mathematical excuses.
At best, it's non predictive modeling.
That’s too facile. I’d say, insofar as it is a science, it’s not about the real world, and insofar as it’s about the real world, it's not a science.
But even that doesn’t give it enough credit.
Too easy to dismiss that much work. And don't blame economists for the crisis. That's politics. There are a lot more lawyers in politics than economists...
We don't discredit the whole of psychological science for the failures of a load of social pop-psychologists. Perhaps, perhaps we can discredit the whole of nutritional science. And even there I'd say we have learned some but that the financial incentives are so biased against proper learning that it's hard to blame the field as a whole.
Probably the best piece of economics I've seen is Coase's theorem. While we base our laws on this idea, it's still a shaggy dog story, and basing it on dialectical materialism, the divine right of kings or Schmitt's friend/enemy principle would work just as well. Citation: places which never heard of Coase's theorem work/worked just as well.
The absoluteness of the efficient market hypothesis also leads to some interesting paradoxes that don't make much sense when you look at the real world: https://en.m.wikipedia.org/wiki/Grossman-Stiglitz_Paradox
Maybe you can say that weak EMH is true, that is, that the market is mostly efficient (and I believe that, as a professional market practitioner), but there will always be opportunities to make superior risk adjusted returns giving enough skill and wit.
Imperfect markets (real ones) are not efficient.
Also, it's predicated on all participants having perfect info, which doesn't happen in the real world.
Is it useful? Mostly no, in my opinion, other than realizing that when my own idea of valuation differs from the market's, it's usually because I'm missing something.
People have come up with two classes of explanations, touched on in the article. One is human behavioral factors and cognitive biases, the other is structural biases in the economy, like investment managers being more incentivized to avoid relative losses than to make absolute gains.
He has shown that markets are only efficient if P=NP, but that doesn't say much about whether they are therefore inefficient.
He also states this, but even an overwhelming amount of strategies can be condensed into algorithms that makes 99% of them useless. See the game of chess for similar ideas. 99% of the possible moves are useless, so it seems as if there are an exponential amount of good moves when only a fraction are viable. Chess is NP, but still partially solvable under P conditions. I believe the market is like this too.
I can tell pretty much everything I need to know about a person based on which one of these ideas they would say or defend.
Always lots of new ideas and theories that hope to reduce the participants in a market down to an explainable behavior.
But there are lots of ways to extract value from a market, which is more important than the debate around "already 'efficient' or not".