Proof of the efficient markets hypothesis

In, surprisingly, The Guardian.

Today, online trading by retail investors is a huge industry. In the UK, many thousands of amateur traders log on each day in an effort to beat the market – that restless sum of countless, competing bets on the value of stuff. In the main, they fail. And fail quickly.

Quite. What the EMH is trying to tell us is that markets process the information about what prices should be in a market efficiently. Thus, unless you have information which is not known to the market in general (something which weak versions of the EMH allow and strong versions do not) you cannot beat the market.

And as you as an individual trader are most unlikely to have such information even the weak EMH says that you shouldn\’t try to beat said market. Because you won\’t.

Optimists reckon that 80% of amateur traders lose money, which many have borrowed. The figure is probably closer to 90%.

There we go, real world proof that the EMH is correct.

13 thoughts on “Proof of the efficient markets hypothesis”

  1. The amateur traders are probably irrelevant in the grand scheme of things, but in general I thought that lots of market participants, with different ideas, trading as frequently as possible, is what helps to make the market efficient.

    If so, thanks to everyone who have helped to make my low cost index trackers a better investment for me.

  2. You don’t of course have to “beat the market” to make money. I think it’s a rather curious phrase.

  3. So its efficient because 90% of the small traders lose money? The inference is that only people on the inside make money.
    BTW I often ask ,somewhat plaintively, on blogs like this, what use the stock market is to the general economy.But answer comes there none.

    Tim adds: Value of stock markets? Allocation of capital dear boy, allocation of capital. We do have to have some system of doing this. Who works what where with whose wonga?

    It’s possible to have different systems of course: bureaucrats, dictators, command economies and so on: but markets seem to produce the largest amount of what we’re after, economic wealth.

  4. I’m pretty sure I read that something like 90% of fund managers don’t beat the market either.

  5. “So its efficient because 90% of the small traders lose money?”

    I’m not sure he means this, I think he means 90% fail to beat the market.

  6. Allocation of capital ?How is it efficient for a bunch of public school twits to buy shares off others of the same sort,with not a penny of it going to the companies involved? Indeed these shareholders ,who have never been a hundred miles of the firm and have never invested anything in it ,have voting rights which a)allow them to sell the firm to some jackass asset stripper (jackasset stripper) who has borrowed the purchase capital and intends to make the firm shoulder the debt a la Man Utd. or b) force the firm into short termism to stop them baying at their heels.
    Germany has loads of Mittelstand firms why don’t we?Oh of course we have the wondrous City which must never suffer the sectoral unemployment everybody else has to put up with.

    Tim adds: If you’re not prepared to learn about how having a secondary market reduces capital raising costs in the primary market then there’s little hope for you. I suggest you look it up actually.

  7. MUFC’s actually a great example of how Anglo-Saxon capitalism works.

    Despite all the whining from fans over the takeover, under the Glazers’ management the club has continued to perform well at football. Meanwhile, they and their bondholders have lost some money (in refinancings, etc), at no detriment to the club.

    If you’re a small company reliant on bank overdrafts, debt can be a problem, because they can pull it at any time and take the hit: “this’ll bankrupt you even though you’re a viable business, but we’ve got second dibs after HMRC on whatever we can sell including your house – and taking a 50% write-off on the million quid we’ve lent you fits better with our risk management objectives than lending you two million quid til next year”.

    But if you’re a big company with bondholders, like MUFC, the incentives of creditors are *exactly the same* as those of shareholders: for the company to continue to make as much money as it can, so they can make the maximum return on their assets.

    Anyone who thought that the need to pay bondholders was ever going to be allowed to impair MUFC’s performance on the field was always, literally, gibberingly, insane.

  8. Oh dear indeed.
    Mr Worstall writes in his patronising way that the point of markets in stocks and shares is “allocation of capital dear boy” (seemed kinda funnier when Macmillan used that line; I am old enough to remember BTW)).But in patronising Murphy in “Oh dear “he writes. “The assumption that the markets are efficient is not that they allocate resources perfectly.”Bit of a contradiction old chap,old fellow,old fellow me lad.
    john b
    Man Utd lost the premiership title this season .For the first time in years.You talk about the maximum return on assets. That’s why they sold Cristiano Ronaldo and did n’t give Ferguson all the proceeds to buy an equivalent player I suppose.
    All this return on assets guff was in play when Charles Clore took over the Northampton shoe industry: only the Crocket and Jones ,Trickers end of the market remains. And Clore was no asset stripper.That was a later generation of full-on asset strippers who bought firms that were employing loads of people but not making much money for the shareholders ,stopped production and sold everything separately, especially the land.Plenty of returns on assets; no manufacturing industry.

    Tim adds: ” “The assumption that the markets are efficient is not that they allocate resources perfectly.”Bit of a contradiction old chap,old fellow,old fellow me lad.”

    You’re clearly having reading comprehension problems. If you look around here you’ll see that I repeatedly point out that given that humans are fallible so will any system designed, run or inhabited by humans. The best we can possibly hope for is to find a system which works less badly than others.

    Markets do not allocate resources perfectly. There is a huge literature on why and when they don’t (things like externalities and so on) up to and including the fact that humans can be a bit dim and get carried away by bubbles, group think and “animal spirits”.

    That markets are not perfect does not mean that we should not use markets: the relevant question is do we have any other method which works better at the allocation of capital?

    A cursory glance at the world around us can aid in answering that question. Those countries which have, by and large, used markets to allocate capital for the last century or two are, by global and historical standards, stinking rich. Those economies which have only adopted markets as their capital allocation method in recent decades are becoming, by those global and historical standards, becoming stinking rich. Those countries and economies that do not use markets to allocate capital and which have not used markets to allocate capital in the past are still stuck in Malthusian destitution.

    We can thus, as a rough rule of thumb, conclude that while markets are not perfect in their allocation of capital that they are better at allocating capital than any of the other systems we have so far devised.

    In short, market allocation of capital is one of those examples of not letting the perfect be the enemy of the good.

  9. I would say that the stock market is very close to an efficient market, and thus it is unsurprising that many people lose money from them.

    Basically, one of the theories of an efficient market is that the net effect of speculation is zero. Thus, when traders “play the market” they are competing in a zero-sum game. Hence, only the best can make money from it.

    However, investing (rather than playing) in the stock market has historically been shown to provide some of the best returns. The difference is that people are banking on long-term growth rather than taking advantage of short-term fluctuations.

  10. So now the revised version is : markets are imperfect and allocate resources imperfectly.Fair enough,no problem with that.
    Your argument ( I restrain myself from sarcastic subordinate clauses) is that stinking rich countries have laissez faire markets & stock exchanges so that proves it.In defiance of the maxim that correlatives don’t prove causation.You don’t think that British involvement in the slave trade, a huge network of shipping companies transporting raw materials back to places like Liverpool,even after the plantations were freed of slaves (they used Indian indentured labour instead ),the use of local coal and iron to process cotton,tobacco (Ogdens) sugar (Tate and Lyle) had more to do with it? The Dutch were well in the lead commercially,and more or less invaded England in 1689,but went spectacularly bust because of their well-developed tulips-futures market,allocating resources not perfectly but in the best possible way in this the best of all possible worlds.

  11. DBC Reed:

    All of the above discussion has centered on the most usually-accepted function of markets in allocating capital among various subsectors. I’d make just two comments for your consideration.

    First, as to the matter of how closely markets come to achieving “perfection” in such allocation.

    You seem to grasp well that markets are not “perfect” ; presumably, they might be closer to perfect if their human actor-inhabitants were more “perfect.” But we’re only speaking here of the correctness of their cognition of the future and, to the extent that accuracy of cognition were more widespread, greater agreement as to the shape of that future would prevail–rendering the markets themselves progressively less necessary
    or useful for the allocation of resources. People buy and sell (and produce and consume)–always–with an “eye to the future” and a desire to adjust as quickly and as costlessly as possible to what seem to be changes, whether originating in their own minds or in the perceived actions of others. For virtually everyone (not only particularly active market participants) the market data come close to “reading the minds” of all those others upon whom at least part of their own future well-being may depend.

    But there is a far lesser-known (though dramatically important) function that the market (particularly the market for “shares”) provides–an absolutely vital function. This was elaborated in 1920 by Mises (of the “Austrian School”), described as “the impossibility of economic calculation in a socialist commonwealth” but, as with many insights of the Austrians, has been largely neglected by mainstream economists.
    In a nutshell, in the absence of a market for the shares in his concern, the entrepreneur is up against a knowledge void when it comes to assessing the “I” in “ROI” and, therefore, “flying blind.”

    You’ve accused me before of being patronizing. But I would rather admit to “tedious” (I just don’t know any better.) What I’d urge you to consider is that the “calculation problem” burdens not only the managers of a would-be socialist commonwealth but also everyone connected with the management of anything by a government (or even other non-profit) entity. When the activities of government are confined to a few well-defined spheres (defense, police, etc.), the “body politic” can simply rely on the acceptability of the services received–their efficacy, etc.–and how much they’ve shelled out for same (are we getting value for what we’ve paid?); there’s no need for more exactitude.

    But what are the values of buildings employed, whether for writing laws or educating schoolkids? What’s the value of a park, a skyline, a coastline, or a climate? Why does it make more sense for the government to collect rubbish and deliver the mail or something called “health care” than the entities which would engage in these pursuits privately?

    I’m going to leave it there. You can read Mises yourself if you care about such things.

  12. A record: Gene Berman goes twenty-three lines without mentioning von Mises.

    BTW it is quite easy to assess the value of views, parks etc: they show up as a premium in the surrounding land values.(There is always an argument that LVT will cover everywhere in buildings but parks,green spaces and lakes pay for themselves although they pay no tax,by putting up the tax take from adjacent property)
    My turn to be tedious.

  13. DBC Reed:

    No–you’re not being tedious at all. You’re raising an argument similar to that meeting Mises’ original observation: that “planners” would be able to resort to a variety of proxies or surrogates
    for market prices (or even to use actual market prices occurring on nearby or otherwise similar free markets), sometimes referred to as “shadowing.”

    Actually, there exists no irrefutable Austrian theoretical argument to prove the untenability of such forms of valuation. Austrians are frequently
    derided as mere theorists, incapable of employing supposedly rigorous empirical (especially mathematical) methods to their analyses. But, at least in view of unfortunate hindsight afforded us now by a separation of almost 90 years since the “armchair” formulation of Mises’ theory, we have plenty of evidence of the empirical sort: the utter (and massively destructive of both life and the material adjuncts to human material well-being) failure of each and every socialist attempt.

    The valuation process in a market economy is driven by the desire of every participant to “make profit/avoid loss”–not just that of the larger entrepreneurs; each watches out for his own “pocket.” In this vital process, the State or its
    presumably “expert” subalterns is always in the position of an outsider who cannot understand or integrate what is “going on.” His pocket will not be affected by losses (except many-times diluted–as a taxpayer; nor will he share–except in the same fashion–from gains).

    If authority–the state and its coercive powers–were confined to the delivery of the limited goods and services dependent on that monopoly of violence (defense, police, and the courts), the citizenry could well stand its inherent incapability and easily shrug off a profligacy here and there. But when that same coercive power is intruded into (virtually) every nook and cranny of market activity, the effects are disastrous–and predictable so. You’re living in what I’m talking about (and there’s substantially worse to come, almost no matter where you might happen to live).

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