Thursday, February 4, 2010

More debates on EMH

The much debated Efficient Market Hypothesis (EMH) revolves around two implications of the claim that market prices are efficient - prices of all traded financial assets reflect all known information (and therefore market prices are always right) and nobody can predict the market it on a sustained basis (and thereby beat it continuosly).

Nick Rowe has two interesting observations on the EMH

1. In the first Nick Rowe explores the interaction between the extent to which EMH is believed to be true with the extent to which it is actually true by using a standard demand-supply curve. He writes,

"The downward-sloping (hence "demand") curve shows the extent to which EMH is true as a function of the extent to which people believe EMH is true. At one extreme, if nobody believes that EMH is true, so people believe there is no relation between market prices and fundamental values, then each individual has a strong incentive to research carefully the fundamental values of assets before buying and selling, and so market prices will reflect all the information available to everyone, so EMH will be true. At the other extreme, if everyone believes EMH is true, so that market prices already reflect all available information on fundamental values, then no individual has any incentive to collect and process that information, and everybody picks assets by throwing darts, or buys the index, so market prices will not reflect any available information on fundamentals, so EMH will be false.

The upward-sloping (hence "supply") curve shows the extent to which people will believe that EMH is true as a function of the extent to which it is actually true. If EMH is totally false, people will (eventually) learn that it is false, and that it is sensible to collect and process information on fundamental values. If EMH is true, people will learn that too, and won't bother to collect and process information. There will probably be lags in both curves. There will be a lag in the supply response if learning the extent of market efficiency takes time and experience. There will be a lag in the demand response if it takes time for market prices to drift away from fundamental values when people stop collecting information and start throwing darts instead. Maybe you can get a cobweb model out of these lags...

If a change in the market structure (allowing short sales?) made the market a more efficient processor of information, that would be represented by an upward/rightward shift of the demand curve. Note that a shift in the demand curve would be partly offset by a movement along the curve. A decrease in the costs of collecting information would be represented by a leftward/upward shift in the supply curve (more people collect information, thereby acting as if they believed EMH were false. Again, the shift in the curve is partly offset by a movement along the curve."

2. It has often been argued that EMH is more a figment of the imagination (or abstruse theoretical models) of ivory tower academics and is almost unknown among traders. Taking a cue from this, Nick Rowe draws the distinction between EMH from the perspectives of the Econ Dept, for whom it makes a lot of sense, and the Business School where it makes much less sense.

About the difference between the two schools, and more specifically between business and economics, he writes that the Business School asks the question, "How can I maximise profits?", while the Economics Department teaches the question, "When you put a bunch of people together, each one trying to maximise profits, what happens?". He writes,

"The Biz Skool student says "I'm going to start a hamburger stall on Main street; it's a great profit opportunity!". The Econ Dept student should not reply "Don't be silly; if it were profitable to start a hamburger stall there, someone would already have done it!". The Biz Skool student is merely doing what the Econ Dept student's theory says he will do: hunting for profit opportunities. And if all the Biz Skool students did follow the Econ student's advice, then there would be an opportunity for profit, and the Econ student's theory would be wrong... EMH applied to markets for financial assets is no different from EMH applied to markets for hamburgers. Are you a player/entrepreneur? Or an observer/economist?"

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