On that efficient markets hypothesis

I think this is about as good a demolition of the idea that all our current problems are down to the efficient markets hypothesis as I think you\’re going to get. Do read it all but:

Toward the end of the book, Fox concludes that passive investing is the right choice for almost all investors. My academic friends in behavioral finance (for example, Richard Thaler) almost always end up with a similar conclusion. In my view, this is an admission that the EMH provides a good view of the world for almost all practical purposes. At which point, I say I won.

8 comments on “On that efficient markets hypothesis

  1. I don’t know why so many economists conclude that passive investing is the right choice. It is the right choice from a narrow individualistic perspective, but not from the point of view of the overall economy. Active investors keep share (and other asset) prices tied to the real economy, with important consequences for factor allocation decisions in the real economy. If allocation decisions in the real economy suffer, then the performance of the index passive investors are tracking should suffer too. There is a classic externality to active investment – the expected private returns are zero or negative, and social returns are large.

    What economists should be doing is advocating active investment, and thinking up ways of aligning private and social returns.

  2. But Luis, economists would be lying if they were telling people that it was better for them to engage in active investment than in passive investment, wouldn’t they?

    Also, I’ve yet to see any economist saying that it is better for the world if people invest passively than if they invest actively, what is normally said is that it is better for the individual to invest passively than actively…

  3. I think most of the current problems are due to mispricing of assets (bubbles) caused by excessive credit creation linked to central banks thinking they know enough to manage to economy. The problem for private investors is that believing the central banks have got it wrong may be correct but is not sufficient to profit from that opinion. You can go broke quite quickly betting against a bubble.

    The banks’ mistake was investing in OTC credit backed securities which were not openly priced and tradeable. Far from an efficient market or assumptions thereof being to blame, there was no market at all. Speculators were not in a position to short mortgage backed securities whatever their opinion, which allowed the mispricing to continue until banks had far more on their books than they could handle.

  4. Was it Samuelson who said that the market was efficient at the micro level (hence you should buy a cheap index fund – you can’t pick winning shares) but not at the macro level, ie the share market in aggregate (other assets too of course) may be wildly and indeed obviously mispriced for long periods.

  5. An active investor invests a large chunk of his time, and as a return gets a better percentage return on his cash investment. If his cash investment is very large then that extra return pays for his time. If his cash is limited then not so much. How many hours a week are you willing to spend raising your return from, say, 5% to 20% p.a when you’ve only got twenty quid to invest? I’ve no idea where the exact cutoff is, but the idea that most people have insufficient funds to invest for detailed research to be worthwhile seems pretty likely to be true.
    Fortunately there are sufficient active investors to provide the crowd that determines the market price of whatever is invested in.
    Another reason to hate government investment, and praise rich, successful people (they of course do get paid anyway).

  6. demolition of the idea that all our current problems are down to the EHM

    agreed: but I would suggest that interpreting the conclusion for practical / policy purposes requires some subtlety

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