Penny finally drops on the "efficient market" hoax.

Correct but when you average the decisions of lots of market traders over long periods of time you achieve better results than any one individual could achieve.

Look at the share prices of the Irish banks despite what the banks, the regulator and the government was saying. Sure it was always possible the market got it wrong but it correctly valued the banks as being essentially worthless.

I think what has really been realised is that the market is not “always right” - that’s different to the efficient market hypothesis (which is manifestly invalid but is a handy mathematical approximation). That the market is always right was a central tenet of much of the philosophy behind regulation. This idea that the market is always right came from the notion that markets correctly and rationally assimilate information very rapidly. Of course we know that’s nonsense - even over a long period of time the averaged views of traders etc was completely wrong ( for example over the past decade - and that’s a LONG time in market terms). This assumption that the market correctly values things and correctly prices in risk is a weird re-mapping of the “mob rules/herd mentality” to “wisdom of the masses”. Very odd, counterintuitive, damaging and, ultimately as we see, wrong.

I would disagree with this - at any particular time the market may well be wrong but the point of regulation should not be to correct particular market errors but to instead to ensure that the overall system incentivises behaviour which leads to long term growth.

For example if the market was completely unregulated a company could simply lie about its earnings. The incentive would be to just be a better liar rather than to produce more growth. In such an environment the market would support greater liars but this is a product of the framework that was created rather than of free markets themselves.

In the current meltdown we had a problem whereby every individual within the system was incentivised to act irrationally. Builders increased their prices because the mortgage was someone else’s problem, banks didn’t care either because they were selling on the debt anyway, those buying it didn’t care because they were rated AAA, those rating it didn’t care because their models calculated almost zero risk, those insuring the risk didn’t care because the risk was negliable. At every stage the people involved got more and more money the more they engaged in risky behaviour and it all inevitably exploded.

The market behaved in a very predictable fashion given the conditions and sadly not for the first time.

Again the idea isn’t the free market is the best possible system only that it’s better than other systems. Which means of allocating capital are you proposing to replace markets?

So the average of lots of traders is the market average…no surprise there. The sensible option for an individual would seem be to invest in index linked funds, you get the average return but cut out the middle man.

No I’m not talking about average market return versus individual return.

Remember the markets make returns but their primary purpose is to allocate capital. They connect people who have money with those who want money and attempt to calculate the risks in return for a fee.

Some people believe this entire system is essentially a hoax and adds no value. I guess what they’d propose as an alternative varies but it’s usually some form of socialism or communism i.e. government bureaucracy decides who gets allocated capital.

On the other end of the scale others believe the markets always produce optimal results because the markets always include all available information. This is at least partially correct **but ** we don’t want markets to exist to simply allow individual traders to make money (we have casinos for this) we also want them to have to invest in genuinely wealth creating business and grow the economy in order to make money.

The challenge is in regulating the whole thing effectively to get it to do what we want without being overly restrictive.

Edit: I’m a layman trying to get my head around this just as much as anyone else, could always be totally wrong, past performance no guarantee of future returns etc.

I don’t agree with the notion that recent events disprove the efficient market hypothesis. The market efficiently incorporates available information into a given price. Take the share collapse of any of the Irish banks. All the way down, the banks denied they had a problem, and kept posting spectacular profits. Irish officialdom backed them to the hilt. Irish brokers shilled like there was not tomorrow. There was a fair bit of scepticism which grew as time went on. The price of the shares at any time reflected the published earnings, and the tug of war between executive denials/Central Bank and Regulator reassurance/Irish broker recommendations on one hand and the scepticism of some market participants on the other. Over time, the sceptics won out and the price reflected that. The slow gradual collapse of the price efficiently reflected the gradual dominance of the sceptics over the vested interest denials.

What has to be remembered is that information is made up of facts, **plus ** the opinions of qualified participants who interpret those facts either positively or negatively, and it is the sum of all these that the market reflects in its pricing at any given time.

Markets are better at efficiency
good Governments are better at reducing risk.
The markets are crap at pricing and reducing risk
hence banks blowing up all the time.

Some activities such as policing are just to risky to be handed over to the markets no matter how much more efficiently the markets would run them because It’s just too risky.

Efficiency is over rated at th expense of redundancy.

i believe that the recent turmoil displays that markets are efficient, too much so for the various world governments at the moment.

It isn’t the markets fault that bubbles are created or assets under/over valued…thats what the market is there for, to let the people (market participitants) decide.

And everyone should know, that, as in all economics/finance.fin eng…the model is there to help, EMH is only a model.

Arbitrage itself shows clearly that EMH holds, the limits to arbt theory describes the time variant that as JPM said, markets irrational longer than your solvent…


OK…I don’t understand any of this. Was ewd3 playing non sequitur without warning us?

This wasn’t market irrationality. It was perfectly rational for the builder to sell for as much as he could get and for the banker to book as much profit as he could. The main problems were in banking regulations and in planning regulations. Banking was particularly badly regulated and acted badly…much as you can have a perfectly rational market that results in battery acid or farm slurry or milk being dumped in streams. Government is what sets the rules for markets. Externalities such as pollution or systemic financial damage need to be considered by regulation.

This was - among other things - an example of bad regulation (and in some cases deliberately bad regulation, e.g. the pressure on FMae and FMac) causing a market in timebombs, a giant game of exploding pass the parcel where the taxpayer in particular is now left holding the parcel.

Oh, I thought I understood it! Maybe I’m too zonked?

Basically, markets will efficiently make prices within the information they know and the rules they know about.

Governments should make the rules on the basis of reducing systemic and individual risk (e.g. capital adequacy, leverage multiples, reporting, corporate governance, employment and whistle-blower rules, lending rules, VaR (FWIW), Texas ratio (basically whatever yardstick they decide to come up with)).

Governments should make sure that market participants stick to the rules and provide proper information.

No matter how bureaucratic or inefficient government regulation becomes, it is preferable to markets doing it themselves, because the markets will not price the risk correctly (there is too large a profit incentive for individual participants to take huge risks to make huge profits - it’s somebody else’s money, they get paid based on short-term results, failure doesn’t matter; once one company starts to do it, the others have to to keep up comparable profit growth).

On the other hand, governments have no ability to price the corporate governance of a company in terms of its trading performance, to promote efficiency as being good for the bottom line and to build a ‘greater than the sum of its parts’ economy, rather than the command economies that tended to be less than the sum of their parts.

Sorry yes that’s what I was trying to say. You can rely on the market to act a certain way so the job of regulation is to ensure you get the kind of outcome you want. If you set things up so that whomever lends the most wins you’ll get exactly that.

Eh - I have a number of issues with this:

Regulatory Capture

Inner circles

Rating Agencies gone bad

Changing the rules

Suspect financial instruments

The guy who’s story has it all - Bernie Madoff:

Sharper - I think we’re actually in agreement. For a start what you call the “free market” is not the usual interpretation - 'cos the “free market” should, by definition, have little/no regulation - otherwise it isn’t “free”. The “market” as some kind of a generic concept appears to work fairly well (at least over the time that there has been the ability for capitalism to increase the population involved in it by expanding across the world - we’re in quite a different scenario now and it’s not clear how well it will fair, but we’ll see). The free market doesn’t work well though, as you’ve said yourself and I agree with that. The thing is, “regulation” over the past decade or so has assumed that the free market does work well and hence regulation should be decreased.

All I’m saying is that regulatory restrictions have to be much tougher and, basically, simpler than they have been. If they aren’t simple then the managers won’t understand them and the regulator won’t understand them either - let’s face it, these financial fellas aren’t whizzes on the old intellectual stakes, though they might be great at running a company … So we need simple, strict regulation. An example would be a simple 3.5 times gross earnings and 80% LTV (whichever is less) cap on mortgages. Simple, direct, enforceable and still leaves room for competition (e.g. in what interest rates are charged etc) - sure, it ain’t perfect, but it’s simple and nothing else is perfect either …

Regulation to prevent fraud is perfectly acceptable in a ‘free market’ - and that’s exactly what financial regulation is - e.g. preventing the fraud of pretending to keep someone’s money safe while actually taking considerable risks with it, or preventing the fraud of saying an investment is safe, because those offering it paid you to say that.

ahh think this shows EMH rather than put it down–its regualator capture…where regualtion infringes on the Market…so ur point is moot.

yet again, weak, soft, strong…it is again market conforming…

what has this got to do with the Hypothesis…

whats this got to do with EMH…

To summize,i don’t see anything of what u said above to dispute the EMH…And remember it’s just a hypothesis…but it helps to conceptualize and understand the workings of a market place…

MOD EDIT: Tidied up the quotes.

I’m not really questioning the EMH but more a question of how can a maketplace be a true market when you have insiders working in concert to defraud and game the system?

Indeed, these would appear to be inefficiencies, would they not? If the insiders are small in number and run serious risk of being caught, then perhaps their influence is negligible, but this really doesn’t look like the case in the last few years. Large trading centres appear to be running small stock markets like casinos with their own rigged tables, just look at the trades in CRH, Elan, on any of the other large ISEQ percentage shares - small lots, just before closing, price way out of whack with the prevailing price; result? the whole market is moved.

Where it is possible to move a market with a few selected trades, this is clearly not an efficient mechanism. I seem to recall James Archer (Jeffrey Archer’s son) being done with a few friends (“the flaming ferraris”) for market rigging on the Swedish stock exchange (ah, here is a story about it … 09,00.html ). The financial gossip at the time was not about what they had done, but that they had been stupid enough to be caught - they had been too greedy in the movements they were trying to make.

Personally, I would close all the small stock markets to trading, stop publishing the market indicies for them and allocate the stocks to larger indices (i.e. there would be large indices that have a published price and on which trades can be made), but not small, thinly traded ones. This wouldn’t stop gray market trading, but it would close them off to retail investors who just aren’t able to compete with this level of manipulation.

Guys, the EMH is just a modeling tool - nothing more. It allows approximations to be made when modeling the market. Those approximations are designed to make the calculations necessary to get data from the models more tractable. That’s all.

I’m curious as to why (a) people are debating this so actively and (b) anyone imagines that the EMH is actually true in the real world. It’s like questioning whether the assumption of water being a continuous medium is correct or not - we know it isn’t (it’s made up of lots of individual molecules so it sure as hell isn’t a continuous medium) but we also know that the assumption works under certain circumstances (which I can go into, but that would take us a LONG way off the point).

To decide that the EMH is not correct we should only need one counter-example to it. It’s easy to come up with that: information is not equally shared/known among all investors in the market instantaneously. Another one is that there are transaction charges. So there are two things which breach the EMH. QED, the EMH is not true in the real world.

The question then becomes this: under what circumstances is the assumption (which we know to be wrong) adequate to allow us to model how the real world behaves? So, if information is generally equally shared/known among all investors at pretty much the same time, though not quite simultaneously, then you might be alright with using the EMH to model the market. Similarly, if the transaction charges are low then maybe the EMH is OK.

We have certainly found over the last while that the EMH is not valid in ways which are important to the macro-economic picture. Anyone should surely, therefore, be very cautious about using any model which relies on the EMH, I would have said.