Are investing results ultimately just good or bad luck? In conflict with intuition perhaps derived from an essential human sense of self-worth, the strictest form of the Efficient Markets Hypothesis (EMH) says yes. Where has the EMH been and where is it going? In his recent article for The New Palgrave: A Dictionary of Economics entitled “Efficient Markets Hypothesis”, Andrew Lo assesses the past and the future of the EMH. Some of his key points are:
To state the hypothesis:
“The EMH’s concept of informational efficiency has a Zen-like, counter-intuitive flavour to it: the more efficient the market, the more random the sequence of price changes generated by such a market, and the most efficient market of all is one in which price changes are completely random and unpredictable. This is not an accident of nature, but is in fact the direct result of many active market participants attempting to profit from their information. Driven by profit opportunities, an army of investors pounce on even the smallest informational advantages at their disposal, and in doing so they incorporate their information into market prices and quickly eliminate the profit opportunities that first motivated their trades. If this occurs instantaneously, which it must in an idealized world of ‘frictionless’ markets and costless trading, then prices must always fully reflect all available information. Therefore, no profits can be garnered from information-based trading because such profits must have already been captured.”
On testing the EMH:
“…tests of the EMH are always tests of joint hypotheses. In particular, the phrase ‘prices fully reflect all available information’ is a statement about two distinct aspects of prices: the information content and the price formation mechanism. Therefore, any test of this proposition must concern the kind of information reflected in prices, and how this information comes to be reflected in prices.”
On investor overreaction and underreaction (irrationality):
“Although such effects are indeed troubling for the EMH, their economic significance is often questionable – while they may violate the EMH in frictionless markets, very often even the smallest frictions – for example, positive trading costs, taxes – can eliminate the profits from trading strategies designed to exploit them.”
On anomalies:
“While calculations of ‘paper’ profits of various trading strategies come easily to academics, it is virtually impossible to incorporate in a realistic manner important features of the trading process such as transactions costs (including price impact), liquidity, rare events, institutional rigidities and non-stationarities. The economic value of anomalies must be decided in the laboratory of actual markets by investment professionals, over long periods of time, and even in these cases superior performance and simple luck are easily confused. In fact, luck can play another role in the interpretation of anomalies: it can account for anomalies that are not anomalous. Regular patterns in historical data can be found even if no regularities exist, purely by chance. Although the likelihood of finding such spurious regularities is usually small (especially if the regularity is a very complex pattern), it increases dramatically with the number of ‘searches’ conducted on the same set of data. …even the smallest biases can translate into substantial anomalies such as superior investment returns…”
On behavioral critiques:
“…psychologists and experimental economists have documented a number of…specific behavioural biases that are ubiquitous to human decision-making under uncertainty, several of which lead to undesirable outcomes for an individual’s economic welfare – for example, overconfidence, overreaction, loss aversion, herding, psychological accounting, miscalibration of probabilities, hyperbolic discounting, and regret. These critics of the EMH argue that investors are often – if not always – irrational, exhibiting predictable and financially ruinous behaviour.”
And in the extreme: “…perfectly informationally efficient markets are an impossibility for, if markets are perfectly efficient, there is no profit to gathering information, in which case there would be little reason to trade and markets would eventually collapse. Alternatively, the degree of market inefficiency determines the effort investors are willing to expend to gather and trade on information…”
“…supporters of the EMH have responded to these challenges by arguing that, while behavioural biases and corresponding inefficiencies do exist from time to time, there is a limit to their prevalence and impact because of opposing forces dedicated to exploiting such opportunities…market forces will always act to bring prices back to rational levels, implying that the impact of irrational behaviour on financial markets is generally negligible and, therefore, irrelevant.”
On the current state of the EMH:
“…there is still no consensus among economists. …EMH, by itself, is not a well-defined and empirically refutable hypothesis. To make it operational, one must specify additional structure, for example, investors’ preferences or information structure. But then a test of the EMH becomes a test of several auxiliary hypotheses as well, and a rejection of such a joint hypothesis tells us little about which aspect of the joint hypothesis is inconsistent with the data. …Moreover, new statistical tests designed to distinguish among them will no doubt require auxiliary hypotheses of their own which, in turn, may be questioned.”
“The desire to build financial theories based on more realistic assumptions has led to…psychological approaches to risk-taking behaviour, evolutionary game theory, agent-based modelling of financial markets, and direct applications of the principles of evolutionary psychology to economics and finance… In particular, psychological models of financial markets focus on the the manner in which human psychology influences the economic decision-making process as an explanation of apparent departures from rationality. Evolutionary game theory studies the evolution and steady-state equilibria of populations of competing strategies in highly idealized settings. Agent-based models are meant to capture complex learning behaviour and dynamics in financial markets using more realistic markets, strategies, and information structures. And applications of evolutionary psychology provide a reconciliation of rational expectations with the behavioural findings that often seem inconsistent with rationality.”
On the Adaptive Markets Hypothesis (AMH):
“One particularly promising direction is to view financial markets from a biological perspective and, specifically, within an evolutionary framework in which markets, instruments, institutions and investors interact and evolve dynamically according to the ‘law’ of economic selection. Under this view, financial agents compete and adapt, but they do not necessarily do so in an optimal fashion.”
“…the adaptive markets hypothesis can be viewed as a new version of the EMH, derived from evolutionary principles. Prices reflect as much information as dictated by the combination of environmental conditions and the number and nature of ‘species’ in the economy or, to use the appropriate biological term, the ecology.”
“The profit opportunities in any given market are akin to the amount of food and water in a particular local ecology…behavioural biases abound. The origins of such biases are heuristics that are adapted to non-financial contexts, and their impact is determined by the size of the population with such biases versus the size of competing populations with more effective heuristics.”
“The extraordinary degree of competitiveness of global financial markets and the outsize rewards that accrue to the ‘fittest’ traders suggest that Darwinian selection – ‘survival of the richest’, to be precise – is at work in determining the typical profile of the successful trader.”
In summary, the Efficient Markets Hypothesis is arguably evolving to incorporate genetic material from the theories of psychology, games, learning and biological evolution.
