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So, now we prove the strong version of the efficient markets hypothesis

The efficient markets hypothesis does not state that markets are efficient at everything. Rather, that they are efficient at processing information about what market prices should be.

The EMH then comes in three flavours, weak (which pretty much all economists sign up to), semi-strong and strong. The strong version insists that all information is already in market prices. Even private and secret stuff – because the people with the private and secret information will trade upon it and thereby move prices to reflect it.

OK, bit of a butchering of the theory but close enough for our jazz.

The strong, ahaha, implication of this is that there is no secret information possible which will enable you to beat the market.

The case shone an embarrassing spotlight on the DGSE’s decision to place about €23 million (£20.3 million) from a secret war chest it had squirrelled away since the First World War into investment funds, mainly in the luxury sector, which had racked up massive losses.

So, even the spies lose their money when they invest. There is no secret information which allows beating the market – the strong version of the EMH is correct.

Saly, this is not an exclusive answer, exclusive in it being the only possible blade to Occam’s shaving kit. Another possible answer is that spies, like all other bureaucrats, are just shite at investing. Tho’ that does rather boost that idea that markets are still efficient, given that bureaucracies are clearly worse.

22 thoughts on “So, now we prove the strong version of the efficient markets hypothesis”

  1. They made the fundamental mistake of not spreading their bets by buying a global tracker. Seems they are no better informed than most active investors.

  2. The secret service proved they had no intelligence when they used Mr Dumenil who already had convictions to handle their money for them. Stupid.

  3. Another possible answer is that spies, like all other bureaucrats, are just shite at investing.
    I’d refer you to a principle I advance on the stinks thread.
    Maybe the individuals tasked (or to more accurate, obtained the task) of choosing the investments did very well out of their choices.
    Like everything else, DSG is an intellectual fiction not an entity. It will be comprised of individuals all seeking to maximise what they perceive as their own personal advantage.
    Which is the strong market hypothesis, isn’t it?

  4. Isn’t that the essential failing of bureaucracies? Inevitably they end up as composed of individual bureaucrats each seeking to maximise their own personal advantage. The bureaucracy itself is just a label for the process. They are, in themselves, an iteration of the strong market hypothesis.

  5. The EMH does not say that Benjamin Graham and Warren Buffet and other good investors cannot beat the market because it says nothing about the wisdom or stupidity of individual investors. The value of a particular stock to a tax-exempt investor will differ from the value to a higher-rate taxpayer.
    EMH is just, as it says, a HYPOTHESIS upon the basis of which various bits of theory have been developed – some of which provide a first approximation to reality.
    It is also clearly invalid for a few seconds (sometimes even minutes) after a surprising item of news is announced.

  6. “The efficient markets hypothesis does not state that markets are efficient at everything. Rather, that they are efficient at processing information about what market prices should be.”

    Markets are shit at processing pricing information. Things that are obvious don’t get priced in for ages, until some small thing tips everyone over the cliff like a herd of lemmings. The DotCom boom was exactly one such, as was the GFC. Both of those were obvious to anyone with a brain looking at the situation months if not years in advance. I’m a peasant farmer and called both of them well before they happened. So why weren’t the markets pricing in that information that was readily available? Because humans are social herd animals. They don’t like to leave the pack. If everyone else is saying the market will go up forever, then they’ll go along with it. Until some small things happens to precipitate the crash thats is always going to happen eventually, at which point they follow that herd too and crash prices way below what the actual facts deserve. Markets over compensate in both directions – maintaining prices way above what they should be for far too long, and then below what they should be on the downside.

  7. If secret information is also priced into the market, why do so many of our Congresscritters end up multimillionaires after a few years on a $170k salary?

    Front running the market is a thing.

  8. One of these days Big Pharma’s protections will fail and the truth will come out leading to big falls. Where’s that in the price today?

  9. rk

    Truth’s increasingly out and no consequence. Maybe the market is pricing in that there never will be consequences and the bastards will win? Quite simply, too much at stake for too many people?

  10. It’s probably not too surprising that DGSE chose that guy as a frontman. After all that’s the kind of cesspit they tend to swim in. However they should have put better protection in place for their funds than just offering to break his legs when it all went tits-up. What surprised me was that the funds had been around since WWI and were ostensibly a protection against the inherent instability of French Republics.

  11. Jim, I think you might be confusing “efficient at processing information about what market prices should be” with “what market prices at some undetermined point in the future will be”.

    I mean, I genuinely don’t doubt that you predicted that there would be a dotcom crash and a financial crisis, but did you correctly forecast the month, or even the year, when they happened? Because if you didn’t, then the market prices were indeed what they should be.

    Like they say, the markets can remain irrational longer than you can remain solvent, and if they do, then the markets were correct and you were wrong.

    Or, to put it another way, it’s the Bermuda shorts fallacy: if you’re wearing them in February, you’re not ahead of the crowd. You’ve made a mistake. And the fact that everyone ends up wearing them in July doesn’t mean you were right to wear them in February.

  12. I preferred it when spies and counter-spies we’re called things such as “Deuxième Bureau” or “MI5” or “MI6”.

    If the Yanks were to adopt that fine old habit we’d have delights such as “Intelligence Modality 17” and “Security Facility 25”.

  13. Dunno about Jim but I sold all our equities in late 1999 and bought gilts. The absolute amounts were modest but preserving that capital was a great relief.

    As for the GFC: all I did there was look at the pictures of the queues outside Northern Rock in 2007 and think “canary/coal mine”. Lehman Bros collapsed a year later.

    My only other claim to stockmarket acuity was shrugging off Black Monday in 1987 as a mere silliness. We didn’t have much in the way of investment but I left it all untouched.

    What I have proved useless at is knowing when to buy equities again. Is that a general experience? Is ‘timing’ selling easier than ‘timing’ buying?

  14. I don’t know about the ‘selling’ versus ‘buying’ problem, dearieme, but your general experience rather illustrates what I was trying to say: you got some things right (foresaw where the market prices were too high and sold), but got others wrong (didn’t foresee where the market prices were too low and didn’t buy).

    So, in the end, it all averages out – the bits you got right as opposed to the bits you got wrong – and overall, on average, on a long-term scale, the market prices turned out to be more or less correct.

    What you can’t do (and what you, to your credit, haven’t done) is give examples of where you were eventually proven correct, and offering those as proof that market prices are inefficient, while ignoring where you were wrong, and the market prices knew more than you did.

  15. “I mean, I genuinely don’t doubt that you predicted that there would be a dotcom crash and a financial crisis, but did you correctly forecast the month, or even the year, when they happened? Because if you didn’t, then the market prices were indeed what they should be.”

    If there is even a 10% chance of a massive meltdown in the economy in a years time, shouldn’t the market be factoring this into the price now? Not powering ahead on the assumption that ‘everything is different this time’ and ‘everything always goes up’? I mean there were articles in the press in 2007 waxing lyrical (in a ‘look how rich we are all going to be!’ way) about how the average house price was going to be some huge amount in X years time, based on how much prices were rising. If markets were efficient at processing information that sort of hubris should be factored in well in advance, but it never is. Prices never decline slowly into a recession/slump, they go upwards to the stars then crash to the floor. Herd mentality, and there’s nothing efficient about that sort of behaviour.

    But as I often say when someone is decrying some idiot behaviour or other – don’t complain, all the idiots behaving stupidly make life easier for the rest of us who have brains and use them.

  16. I am a full time investor for over 30 years. My CAGR over that time was about 18%, this in a Canadian market that was about 6% over at least a twenty-year period of that time. So basically an alpha of about 12%. I’m a value investor in the style of Buffett and Graham. I’m proof that value investing still works.

    The reason that EMH fails is that just because information is widely available does not mean that it is known by most market participants. Information lies upon a spectrum from that which is clear to that which is obscure. There’s a saying that if everyone knows something, it’s not worth knowing. The stuff that makes you money is in a footnote on page 67 of a 200-page annual report. Most people have neither the time nor the expertise to read annual reports. That leaves managed money.

    The problem with managed money is that it is just dumb money at one remove. When the market is climbing, money floods into the market and the money managers have to invest it. When markets are crashing and bargains abound, retail investors are hitting the sell button. The retail investors also choose which sectors to invest in, chasing the sectors that have done well in the past and avoiding the sectors that will do well in the future, i.e., chasing past performance. As an aside, most money managers do well when they invest for their own account, often doing the opposite of what they’re doing for their clients.

    Incidentally, this is known as the Law of Conservation of Stupidity: “Stupidity is never eliminated, it just moves from place to place.” Money managers do not transform dumb money into smart money. Dumb money remains dumb money.

    As an aside, saying that smart money moves markets making EMH true is like saying smart voters determine elections. They don’t. For every informed voter, ten uninformed voters show up on election day and dilute away the power of that informed vote. That’s why I don’t vote. It’s dumb money that moves markets, which allows smart money to earn alpha.

  17. A few quotes from this article that describes what I was saying titled “Smart money, dumb money, and capital market anomalies”:

    “We investigate the dual notions that “dumb money” exacerbates well-known stock return anomalies and “smart money” attenuates these anomalies. We find that aggregate flows to mutual funds (dumb money) appear to exacerbate cross-sectional mispricing, particularly for growth, accrual, and momentum anomalies. In contrast, hedge fund flows (smart money) appear to attenuate aggregate mispricing. Our results suggest that aggregate flows to mutual funds can have real adverse allocation effects in the stock market and that aggregate flows to hedge funds contribute to the correction of cross-sectional mispricing.”

    “Flows to mutual funds have been shown to create distortions in capital allocation across stocks. Retail investors appear to contribute to these distortions in several ways. Sirri and Tufano (1998) show that retail investors tend to “chase performance” by directing money to mutual funds with strong recent performance, while failing to redeem capital from funds with poor recent performance. Frazzini and Lamont (2008) show that retail investors tend to direct dumb money to mutual funds that hold overvalued stocks. When mutual fund managers receive new flows from retail investors they usually increase positions in existing stock holdings. As a result, in the cross section of mutual funds, net money inflows are associated with higher contemporaneous returns and subsequent return reversal (Coval and Stafford, 2007).”

    “We also contribute to the literature on the dumb money effect shown by Frazzini and Lamont (2008) and by Lou (2012). We demonstrate the existence of a dumb money effect at the aggregate level: The new money flowing into mutual funds appears to be, at least in part, originating from the dumb investors described in Frazzini and Lamont’s paper.”

    Here’s a link:

  18. EMH does not “fail” because it doesn’t try – it is just a Hypothesis. Structures built upon the assumption that EMH is true may lead you to a sstrategy that fails.
    If you want say MPT does not accurately represent the real world and investment strategies based thereon are likely to fail, you are very welcome to do so.

  19. john77,

    Yes, EMH only holds true if no one believes in it. That’s part of the hypothesis. Here’s a quote:

    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.
    [end quote]

    There’s more at the article with a supply and demand chart.

    Title: The supply and demand for (belief in) EMH


  20. @ phoenix_rising
    Thanks: good link.
    Slightly hyperbolic article but it does point to one of the fundamental paradoxes – the cheap passive index funds for the non-expert investors have to depend on the professional investors running the active funds for price discovery.
    The EMH hypothesis does not say anything about whether people believe in it or not.

  21. “The EMH hypothesis does not say anything about whether people believe in it or not.”

    You might be right on that. I have however seen that repeated endlessly in the investment literature, so it might be people adding onto Eugene Fama’s original work, which I haven’t read.

  22. @john77
    What you’re talking about it is basically the Grossman-Stiglitz Paradox, although telling you this might just be teaching you to suck eggs.

    The Grossman-Stiglitz Paradox is a paradox introduced by Sanford J. Grossman and Joseph Stiglitz in a joint publication in American Economic Review in 1980[1] that argues perfectly informationally efficient markets are an impossibility since, if prices perfectly reflected available information, there is no profit to gathering information, in which case there would be little reason to trade and markets would eventually collapse.[2]

    Rational efficient markets formulation
    The rational efficient markets formulation recognizes that investors will not rationally incur the expenses of gathering information unless they expect to be rewarded by higher gross returns compared with the free alternative of accepting the market price. Furthermore, modern theorists recognize that when intrinsic value is difficult to determine, as is the case of common stock, and when trading costs exist, even further room exists for price to diverge from value.[3]

    A corollary is that investors who purchase index funds or ETFs are benefitting at the expense of investors who pay for the services of financial advisors, either directly or indirectly through the purchase of actively managed funds.[4]

    There’s also a lot of behavioral finance research on how investors (mis)use information. Chris Dillow pbuh has a good short piece about it:

    One has been pointed out by Alexander Todorov at Princeton University. He got students to predict the result of a basketball game and found that as he gave them more information about the teams their predictive ability declined while their confidence in those worse predictions increased. Information, he concluded, can worsen decisions by giving people an “illusion of knowledge”. Retail investors are prone to this. Economists at the University of Mannheim have shown that even the most knowledgeable investors often hold high-charging poorly performing funds because their knowledge gives them a misplaced faith in their ability to spot good fund managers.

    One reason for this illusion of knowledge has been uncovered by other researchers at Princeton. Experiments by Anthony Bastardi and Eldor Shafir show that people place too much weight upon information if they have taken trouble to get it – even if that trouble is merely waiting a while. Information, like many other things, is subject to an endowment effect: we overvalue it simply because we’ve taken time and effort to acquire it. This can lead us to trade upon useless or stale information. And the more of it we have, the more likely we are to do so.

    It’s not just our own information we can have too much faith in: an information-rich world can cause us to have excessive confidence in others’ knowledge. Brock Mendel and Andrei Shleifer at Harvard University have shown that this can lead to investors “chasing noise” – buying assets that have risen because they wrongly believe that earlier buyers know something. In this way, bubbles can emerge. They claim that this was the case in the mortgage derivatives market in the mid-2000s.

    Whole thing is worth reading.

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