Kindly Stop Saying the Efficient Market Hypothesis Is Dead | Hacker News Reader

Kindly Stop Saying the Efficient Market Hypothesis Is Dead

thedeepdish.org

61 pointsjacobedawson66 comments

This seems like a silly point. Are markets more efficient in the infinitely long run than an individual who tries to identify the "correct" price? Quite probably. Does the current stock market price at any given moment possibly reflect the herd mentality of a bunch of jumped-up plains apes (or the injection of a huge amount of funds by a central bank), rather than representing the future expected earnings of a given asset? Also extremely likely.

The performance of the markets during the lead-up to the pandemic was absurd. It wasn't just the top-line market prices that were wrong: the obvious hedges, like Put options, were all massively mispriced, to the point that even banks started warning about it. This eventually corrected, but the correction itself was extremely painful. Now the Fed is injecting dollars in order to help "correct" the correction, with unknown long-term effects. (I don't know what the EMH has to say about prices under this regime.)

Anyway, "the EMH is wrong" is an absurd simplification of the problem. The real objection here is that asset prices may be right on average, in the long-enough term, but are prone to huge over-confidence bubbles and corrections that can wreak havoc on the actual human beings, and possibly lead to suboptimal economic outcomes when prices are used to direct investment.

> obvious hedges, like Put options, were all massively mispriced

As a former options market maker, this wasn’t obvious. That said, every time volatility snaps one tends to find a cohort of investors who got burned blaming the Fed.

EMH is a mental-model of equilibrium, and is useful when used that way.

Financial systems have multiple equilibria [1], so EMH "violations" come in two flavors:

1. Small deviation from equilibrium. This is where Renaissance Technologies hangs out.

2. Market herd expects the wrong equilibrium. This is where Nassim Taleb hangs out.

On the scale of single years, 2 happens so rarely than you can't get statistically significant measurements. So, we end up with endless philosophical debates about whether EMH is "true".

[1] https://en.wikipedia.org/wiki/Diamond%E2%80%93Dybvig_model

>"the EMH is wrong"

The EHM is economists being dimly aware of the third law of thermodynamics, but not being smart enough to make any actual sense of it.

Markets are not rational, they exhibit crowd psychology and as such are more primitive and irrational than individual behavior. Quite a few professional traders, hedge funds and even retail traders consistently outperform the indexes. They are able to do this because they have recognized the fallacy of EMH and are able to exploit the market's irrationality.

> Quite a few professional traders, hedge funds and even retail traders consistently outperform the indexes.

In any one year there are a number of them do, but SPIVA has shown that over the course of 5, 10, and 15 years that number gets smaller and smaller:

* https://us.spindices.com/spiva/#/

Also: just because the market is not 100% efficient, and some folks can find 'weaknesses', does not mean it is not mostly efficient.

* https://yourlogicalfallacyis.com/black-or-white

Not even Fama, whose is often credited for formulating the EMH, has said that it is 100:

* https://en.wikipedia.org/wiki/Eugene_Fama

Replying to myself on the SPIVA point (PDF):

> Over the 15-year period ending June 2019, 90% of large-cap, midcap and small-cap funds underperformed their benchmark S&P indices. In only one asset class, large value (80% underperformed), was the percentage of underperformers below 86%.

* https://www.advisorperspectives.com/articles/2019/11/18/the-...

I don't disagree with the point you're making, but I should point out that one reason some funds don't beat the S&P500 is because of the fees they charge, which are deducted from their performance. In reality, their actual gross performance is better than the S&P. However, the fact that the results are so close to the S&P's performance that the fees alone can push them below it supports your overarching point.

Further, in low-performance years, there is more of a headwind that must be overcome to even earn a return (from the investor's POV).

Although I do not believe the EMH myself, I think it's important to distinguish between rationality and efficiency. Markets are not rational is not the same thing as saying markets are not efficient.

Investors who consistently beat the market are a small minority, and their existence does not disprove the EMH. Obviously the market isn't 100% efficient, but it's efficient enough that even most professionals can't beat it.

I'd imagine the utility stems from being the most efficient means of distributing resources, and if markets can be consistently beat for extended periods of time then that is evidence that a better way exists.

Admittedly that better way might simply be "markets, but only competent people are allowed to trade".

A slightly different, more complete version by the same author can be found on LessWrong. It has some clarifying edits (written in small writing), and there's more discussion in the comments. https://www.lesswrong.com/posts/utySCY9nJt9xGYGGQ/the-emh-at...

For any big market movement you will always be able to find the person who acted on it first. That person will always look like a prescient genius if you just look at that one data point. To show a counterexample to the EMH you would need to exhibit someone who can consistently beat the market at odds better than chance under proper controlled conditions. No single data point can ever do it.

The real problem with the EMH is most people consistently do worse than the market not better. In a completely efficient market every trade should be equivalent, but when you look at what happens when millions of the uniformed try and day trade they on average lose massive amounts of money.

PS: I have tried to time the market exactly 4 times and it’s worked every time. That does not mean the EMH is dead, that’s just like how I am actually up on slot machines and have decided never to play again.

Right. To show the EMH is dead you have to show that someone can beat the market with odds better than chance under properly controlled conditions. In a market with millions of participants, you would expect there to be a few who beat the market purely by luck many times in a row. In fact, in a population of a mere one million people, you would expect to find one person who beat the market 20 times in a row without a single miss by pure luck! Four for four is not even remotely remarkable. One person in every 16 will be able to do that.

Sure, that's all correct. But before showing it is dead it would be useful to have empirical evidence that it was ever alive. And the evidence is very mixed at best. The history of the EMH is a battle between those showing where it breaks from reality, followed by increasingly desperate attempts to save it with some additional explanatory factors.

It's a nice model. But like most economic and financial models shouldn't be held as gospel.

That's like the theory of energy. Energy can't be created or destroyed, until someone does and whatever they did gets merged into the definition of energy.

Worth pointing to this classic: “The Super-investors of Graham and Doddsville” [0] by Warren Buffett.

[0] http://csinvesting.org/wp-content/uploads/2014/10/The-Superi...

Two points about Buffett:

* over the last few years (15?), he's actually trailed the S&P 500 (IIRC)

* 2013 paper "Buffett's Alpha"

> Berkshire Hathaway has realized a Sharpe ratio of 0.76, higher than any other stock or mutual fund with a history of more than 30 years, and Berkshire has a significant alpha to traditional risk factors. However, we find that the alpha becomes insignificant when controlling for exposures to Betting-Against-Beta and Quality-Minus-Junk factors. Further, we estimate that Buffett's leverage is about 1.6-to-1 on average. Buffett's returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks. Decomposing Berkshires' portfolio into ownership in publicly traded stocks versus wholly-owned private companies, we find that the former performs the best, suggesting that Buffett's returns are more due to stock selection than to his effect on management. These results have broad implications for market efficiency and the implementability of academic factors.

* https://www.nber.org/papers/w19681

In other words, Buffett doesn't try to beat the market, he tries to be the market and waits for morons to walk in and lose to it. A bit like running a casino that lets customers set the odds but chooses which bets it accepts. That might be splitting hairs.

> To show a counterexample to the EMH you would need to exhibit someone who can consistently beat the market at odds better than chance under proper controlled conditions.

See perhaps Renaissance's Medallion Fund:

> The Medallion fund is considered to be one of the most successful hedge funds ever. It has averaged a 71.8% annual return, before fees, from 1994 through mid-2014.[32]

* https://en.wikipedia.org/wiki/Renaissance_Technologies#Medal...

People speculate that while mathematically half of trades must win and the other must lose (for each side of a buy-sell), that Medallion may perhaps 'win' something like 52% of trades, but their volume is so high that the (e.g.) 2% gives them their profit just like The House only needs a slight edge when it comes to casinos.

Figuring out whether a given performance level is statistically significant is incredibly difficult. You have to take into account a myriad factors: how many other funds were there? The more total funds there are, the more likely you are to find outliers. What was the risk-adjusted return, and what were the underlying market conditions? It's trivial to take a consistently rising market and amplify its returns: just apply leverage.

The fact that Medallion had this extraordinary return in a period that included the 2008 crash is remarkable, but even then you would only have had to predict a single black swan in order to avoid being impacted by it. And even I saw that one coming back in the day, and I don't really pay that much attention.

The EMH doesn't say anything about anyone not being able to "beat" the market. Only that prices move until they reflect the available information. While prices move, there can be winners.

Also, information is not uniformly available in real markets. That subset of the traders who have all the information will beat those who have only some of the information.

There is a lot left out of the hypothesis. For instance, even if every trading node in the system has access to all the information, do they all have access to every pieces of new information at the same time? If some of them get it before others, then they have an advantage. If all nodes eventually have the information, then the prices will settle according to the hypothesis when new information stops being available.

The article reads like it was written by someone who has a deep interest in finance, but hasn't worked much in the industry. Markets are quite efficient, but there are pockets of risk premia driven by regulatory/intermediary constraints and plain old behavioral bias. Then again, if he knew about them, he presumably wouldn't write about them in an internet blog post.

It might interest some people here to know that if the EMH were true, you could use it to break unbreakable cryptography.

However that's not what would happen. If you tried it, your crack would fail, and you would just end up proving experimentally that EMH isn't true.

That would move the discussion to "is it true except if you test it in weird experiments though?" which is not an interesting point of debate:

Obviously there are no market participants with infinite wisdom and processing ability who know all public news and factor it into every stock's price instantly at all times, and are perfect in their analysis.

And have been since the dawn of markets, even before the Internet.

it's totally obvious.

Anyway here is a protocol you can use to demonstrate EMH is false, any time you want:

https://arxiv.org/abs/1011.0423

This is a fun paper, and the logic seems sound. But the contrived situation is nothing like real life, so it doesn't seem useful as a model.

Here's a dashboard I made that tracks the performance of the average Robinhood user vs. the S&P 500 (using user holding data): https://www.quiverquant.com/sources/robinhood

There's an argument to be made that the ability to consistently UNDERPERFORM the market is evidence against the Efficient Market Hypothesis.

Alternatively, it means that someone has an edge that can be used to exploit RH (or maybe even all retail) investors.

Given the state of the market, this seems ... disturbingly likely.

Trading costs are a thing. In an efficient market I would expect ex-ante negative performance versus the benchmark.

True, although the method I used to find the aggregate performance of Robinhood users ignored trading costs.

Obviously this data is incredibly noisy and nowhere near statistically significant, but I like how it implies that betting against Robinhood traders would've been an alpha-generating strategy over the last two years.

I agree that the data is quite noisy, and the choice of weighting (by users instead of dollar value traded) may significantly influence results. Then again, after reading r/wallstreetbets, I am not so sure ;).

Yeah, unfortunately Robinhood doesn't provide data on # shares held per user.

I've been doing something similar to track discussion on r/WSB here: https://www.quiverquant.com/wallstreetbets/

I haven't finished any backtesting yet to see if they live up to their reputation haha.

William F. Sharpe mentions this explicitly in "The Arithmetic of Active Management" (The Financial Analysts' Journal. January 1991, Vol. 47, Issue 1, Pages 7-9).

He was a co-creator of CAPM (won Nobel) and did the Sharpe ratio:

* https://en.wikipedia.org/wiki/William_F._Sharpe

Or it's all the sports fans not having any other way to spend their time:

> They started betting on what color car would pass next

* https://twitter.com/SportsCenter/status/1264026863367786496

Sure, but part of EMH is that stocks are priced correctly, therefore in aggregate you would expect any sufficiently large collection of random portfolios should have the standard market return.

That’s an interest question. What are the application for a rational actor in the EMH? Can application be reduced or applied to a subset of actors. What are the predictions for a random or misinformed actor in the market?

That chart shows Robinhood as randomly above and below S&P500

Efficient Market Theory is dead because it is unfalsifiable.

It is not capable of being proved false, and should be discarded for that reason.

Information asymmetries exist, not everyone with better information have the access to capital or risk profile to alter the market price of an asset.

Does information or performance asymmetry disprove the theory?

assets can be mispriced, efficient market theory requires stretching the logic to fit the theory. it requires a moving the goal post of to a longer and unspecific time frame to say that someone's outsized gains now are irrelevant, it requires moving the goal post to a greater unspecific amount of capital to say they can't beat the performance of the benchmark.

anyone in any hard science will point out that the theory is unfalsifiable so pick a different theory.

why are we making exceptions for economic and financial theories at all?

Your first two sentences are very interesting.

> Information asymmetries exist, not everyone with better information have the access to capital or risk profile to alter the market price of an asset.

This is talked about in the article and seems to just start an argument again and not explain the unfalsifiable statement.

Sorry if that weakens the argument to you. It is a separate thought. My point is that "asset pricing" theories are too reductive, and should at least factor in undercapitalized people that do not wish to speculate that can perceive information. Or just abandon reductive asset pricing theories and focus on other things. Promote liquidity and increases in transactions, "efficiency" in that context, not "efficiency" in a "it already is and has been all the time and forever" context.

I think it's like the Shinichi Mochizuki mathematical proof.

If they can't play the game are they really part of it?

How do you know if you perceive true information?

I can tell you Magic Leap is a BS company and won't make any actual money. But so can lots of people. So is that 'information', the answer is no. Real information is when it will fail.

and that mathematical proof is much more sound than an economist's Efficient Market Theory. QED.

This is a clarification question (probably for people that have studied or read about the EMH in depth).

Wikipedia's definition is: "The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information."

The sentence above doesn't say how quickly the prices incorporate the information. The rest of the Wikipedia article didn't really clarify my core question (next).

Could someone give a summary of how the EMH is or is not framed in terms of steady-state assumptions? In other words, does the core EMH theory concern itself with dynamics? (Random walk theory does discuss dynamics.)

If there is a variation of theories that are all called "EMH", would you please summarize some grouping you find useful?

Emh is almost tautologically ridiculous. Markets efficiently price the sums of everyones actions based on their opinions regarding the underlying facts. It doesn't price in some objective thing called "information". If one person takes one bet based on a piece of information and another person makes the opposite bet off of a differ wnt interpretation on the same piece of information then neither of their strongly held opinions altered the market price. If skewed numbers of people take those bets based on which side of the bed they woke up on then the market skews to that side. There isnt some conceptually perfect piece of "information" that is being priced here.

Not everyone has the same information, and not everyone interprets the information the same way. All the market prices is the average of these subjective opinions, and sure it does that efficiently, but that does not mean that that price represents some perfect unbeatable truth.

My bank account would also like to disagree with EMH

How does the author explain the Renaissance Medallion Fund?

Also (and I asked this in the last big HN discussion of EMH too), how can EMH co-exist with the existence of 'trading' as a profession? I don't mean day traders, I mean professional traders who work for Goldman Sachs, investments banks, etc. Every asset class in the world has dedicated, professional traders.

If trading is fundamentally unprofitable over a long enough period of time.... why do sophisticated banks employ traders? (Wouldn't they, uh, have figured this out already?) Assuming trading is profitable (for professionals with a massive data advantage, etc.)- doesn't that disprove EMH? I can believe retail trading is always unprofitable, but why do the pros do it?

Hedge funds overall do not outperform index funds in the long run [1]. Banks have moved mostly to sell side and their traders earn commission and bid-ask spread. For a while the most profitable shops are market makers who use high-speed trading to leverage tiny arbitage opportunities, profiting exactly from tiny fluctuations from an efficient market.

[1] http://ftalphaville.ft.com/2018/04/24/1524542401000/A-comple...

>Hedge funds overall do not outperform index funds in the long run

But the Medallion Fund does apparently, which is my point. How can they have 70+% returns year after year for decades in a world where EMH is true? Their existence seems to disprove it, no?

I think there are two important aspects that make the EMH not a good predictor:

- The markets move the prices themselves, so the prices are not the "canonical" ones (if there was ever such a thing) but it reflects the idea that the market itself has.

Betting on a certain outcome in a game doesn't change the possible results, "betting on the market" does. So it's less about the "reality" and more about what the market thinks.

The second aspect can be summed up by the phrase "one person is smart, but people are dumb" (with the added component of "the market can stay irrational longer than you can stay solvent")

So, the market is probably not efficient but that doesn't mean you can beat it with ease.

More interesting than "Is EMH dead?" is our improving understanding of the efficiency of incorporating new information into markets is getting better.

I'll refer you below to Andrew Lo's "Adaptive Market Hypothesis" which:

"is an attempt to reconcile economic theories based on the efficient market hypothesis (which implies that markets are efficient) with behavioral economics, by applying the principles of evolution to financial interactions: competition, adaptation and natural selection."[1]

[1] https://en.wikipedia.org/wiki/Adaptive_market_hypothesis

The analogy I always use (similar to the joke about the economist not picking up a twenty dollar bill) is that the market is as efficient as an evolved jungle ecosystem. Most of us would consider this system highly efficient, certainly more so than one our government could design, but it doesn't mean an animal shouldn't be able to find food. It just means it requires energy to find it -- or, in the economy, to determine a more accurate future price. There's no free lunch.

The efficient market hypothesis has a really questionable name which is a recurrent source of confusion: it's not about markets being efficient (in terms of resources allocation), it's about the inability to efficiently forecast assets price. The former isn't necessary for the later to be true.

This is nonsense, ignoring the social/human aspects of it, the "efficient market" hypothesis only works if competition is possible (e.g. no monopoly, minimal capital startup costs), and if P=NP.

One thing this blog doesn’t address is price elasticity/liquidity.

There is far less friction and chance to get front-run if you are dealing with $100k rather than $100M.

It is trivial to outperform the market by insider trading, thus markets are inefficient. The efficient market hypothesis isn't dead, it was never true.

I think empirically it's neither trivial nor impossible.

For instance, say you are a CEO and earnings are about to be announced for your company. You know exactly what the earnings are going to be, and what the published expectations are, so you know how much they will beat or fall short. Does that mean you know how the market will react? I think people who have been in that position would tell you no.

There was something in the news about someone who hacked into a database with earnings press releases that gave them access just a little early. And someone did an analysis of how reliably this worked to make money. It wasn't 100%!

If you frontrun a merger or a huge earnings miss, there's nearly a 0 percent chance you will lose money, and you can further leverage with options.

the efficient market hypotheis isn't dead, but markets are efficient only if P == NP https://arxiv.org/abs/1002.2284

Someone posted a similar (but later) paper above: https://news.ycombinator.com/item?id=23371766

Finally some sense. I am so tired of people complaining about markets being irrational

“The Market” is a leaky abstraction for the collective activity of millions of individual humans making concrete decisions at specific points in time. The EMH says something about the model, not about reality, so there will always be a gap.

EMH is dead.

Money printer goes brrrrrr.

Effecient markets!

First off, I don't like titles telling me what to do. You're not my real mom.

Second, this was more incoherent babble than useful. While I am an investing nerd, this article could be about 1/3rd as long. The rest was trash writing and ego.

Third, there is some worthwhile content in that 1/3rd that's good. But it's nothing groundbreaking or new, and detached from the EMH topic. His perspective on Warren Buffet was worthwhile, though, and the idea that once a tactic goes public the collective abosrbes it and the edge is lost is worth pondering over, and the comparison of using a stone-age axe against a fighter jet is meaningful too. There's no real discussion around the lifetime of tools, techniques, and perspectives. That might be the most worthwhile takeaway for me.

Forthly, equating market action to coin tossing is intellectual laziness. I would agree with this on an intraday trading level, but in long term investing that's just not the behavior equities exhibit.

Lastly, my portfolio has beat the S&P500 by significant margin (>3-8x) for 5 years. I'm still waiting to get humbled so i can investing in the S&P500/bonds and call it a day. If history is any indicator, it should be an eventuality. But given the perspective that stone-age axes don't work against fighter jets, I wonder how that could come to pass.

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