The Efficient Markets Hypothesis Has Been Proved Wrong But Economists Do Not Want to Listen

emhThe Efficient Markets Hypothesis (EMH) is wrong. It has been proved wrong. Do you think you’ve heard this before? You likely have, but the proof that you’ve heard that the EMH is wrong probably has not done the damage that you thought it had.

When I studied the EMH for my dissertation I noticed that many had thought that the financial crisis of 2008 had proved the EMH wrong. In one way this was true. Investigations undertaken by the authorities had uncovered that people within many markets were actively misleading the public about the underlying value of securities.

After being told that a security was not structured properly an S&P official said that they would rate it regardless. “We rate every deal. It could be structured by cows and we would rate it.” If the EMH says that markets price in risk perfectly then the markets were not operating in the manner the EMH predicted in the run-up to 2008.

Nevertheless, this mattered little for the other claim made by the EMH proponents. The EMH proponents said that you cannot beat the market consistently. Because all information is already priced in then any gains you make over the market will only be temporary. If you beat the market this year, the chance that you beat the market next year will be extremely low. If you beat the market both this year and next year then the chance that you will beat the market the year after will be lower still. Using this reasoning you will, in the long-run, be completely unable to beat the market.

I found this reasoning terribly troubling. First of all, just because most people cannot beat the market does not mean that the EMH is correct. A number of other hypotheses could also be correct. For example, the Post-Keynesian proposition that the future is inherently uncertain and thus that predictive techniques of complex market dynamics will likely fail could also be confirmed by the same observation.

Secondly, the proposition struck me as being tautological. Who was the ‘you’ in the statement ‘you cannot beat the market’? It seemed to me to be the idea of an ‘average investor’. But, as everyone knows, ‘the market’ is simply the outcome of the average decisions of all investors taken together. Thus, ‘the market’ is actually the expression of ‘the average investor’. The two terms — ‘the market’ and ‘the average investor’ — are actually synonyms. So, the statement ‘the average investor cannot beat the market’ could just as easily be read as ‘the market cannot beat the market’ or, alternatively, ‘the average investor cannot beat the average investor’. This struck me as being a purely tautological and highly problematic approach to studying markets. It appeared that EMH proponents were confusing the idea of the ‘average investor’ with any given ‘particular investor’.

Thirdly, tied to the second point and most importantly, it appeared to me that many people do indeed consistently beat the market. The probability of someone like Warren Buffett existing seemed to me, from an EMH perspective, entirely implausible. But then I found something even more unlikely: John Maynard Keynes had, in the 1930s, effectively tracked Warren Buffett’s stock market performance. In the graph below you can see Keynes’ investments plotted against both Buffett’s and the market return in his own time.

keynesBUFFETTAs John Authers wrote in his article ‘Keynes Stands Tall Among Investors‘ when he compares Keynes with Buffett:

What of Warren Buffett, the world’s best-regarded investor? The chart shows how the portfolio of Berkshire Hathaway, his main investment vehicle, has performed over the past 22 years – and the King’s endowment under Keynes did better. Had we chosen the first 22 years of Buffett’s tenure, when his portfolio was smaller, making it easier to outperform, Buffett would be ahead. But Keynes’ record places him in exalted company.
Now, this seemed to me beyond a coincidence. Maybe you could make the case that Buffett was an anomaly, an outlier on the probability map, but Keynes? This seemed doubtful. Was it merely a coincidence that one of the greatest and most famous economists of the 20th century — one who emphasised the unpredictability of the future and the irrationality of the financial markets — was also able to beat the odds? This seemed highly improbable.
But the plot thickened as I pursued this further: it seemed that Keynes had used a very similar investment strategy to Buffett. While in the 1920s he had tried to play some silly mathematical games he had lagged the market. But when he switched to the strategy that Buffett uses he saw his gains soar. Authers writes:
His performance lagged the market in the 1920s, when he used an elaborate economic model to time the market. It did not work, and he failed to spot the Great Crash coming. He admitted that this approach “needs phenomenal skill to make much out of it”. So he switched to picking stocks. Like Buffett, he said he became ever more convinced that “the right method in investment is to put fairly large sums into enterprises one thinks one knows something about”. His results speak for themselves.

Could this all be coincidence? It seemed to me that it probably was not. And then I stumbled on a famous 1984 article by Warren Buffett himself entitled ‘The Superinvestors of Graham-and-Doddsville‘. In the article Buffett discussed a group of nine investors who had substantially outperformed the market in a 20 year period. He accepted that these could all be simple probabilistic anomalies — black swans, as it were — but he noted one important point: they all came from the same school of investing.

Now this did not mean that they all bought the same assets. If they had that would explain the anomaly. But they did not. They all had different strategies and they bought different assets. But they all followed the same philosophy.

As Buffett said in the piece: if there were 1,500 cases of a rare cancer in the US and 400 of them were in a small mining town in Montana good scientists would probably go to the mining town and check the water. Economists do not do this type of research, however, which is what critical realists and other critics of econometric/probabilistic approaches (present writer included) always complain about. But if they did do true scientific research Buffett’s article would interest them greatly.

Looked at from anything resembling a scientific approach it is quite obvious that Buffett’s article proves the EMH completely wrong. It is also interesting that the investment strategy that Buffett, Keynes and the nine other investors discussed in Buffett’s article runs exactly contrary to the EMH assumption of information being priced into markets at all times. Indeed, their investment strategy rests on the idea that market prices often diverge substantially and for long periods of time from the underlying value of the assets.

So, what have the economists said in response? Nothing. Not being scientists but rather moralists and soothsayers they simply avoid contrary evidence when it is presented to them. As the investor Seth Klarman wrote in his book Margin of Safety:

Buffett’s argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what was refuted in practice. (p199)

Economists and business schools continue to teach the EMH, of course. It continues to give off the mystique that markets somehow get the price ‘right’. It does so by being vague to the point of meaninglessness in many cases. But when it does manage to say something concrete and make a claim that can be falsified, it fails. And when it fails its proponents simply ignore the overwhelming evidence to the contrary. This is not science. It is ideology.


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
This entry was posted in Economic Theory, Market Analysis, Statistics and Probability. Bookmark the permalink.

22 Responses to The Efficient Markets Hypothesis Has Been Proved Wrong But Economists Do Not Want to Listen

  1. Karsten says:

    I found this paper by Burton Malkiel very amusing. It seems that neoclassical economists sometimes feel compelled to resort to epistemic relativism when their dogmata are compromised by empirical evidence…

    Click to access malkiel.pdf

  2. ivansml says:

    Even if EMH (in the sense used here) holds, some people will beat the market by chance, a few will beat the market for several periods, and a tiny group maybe even for 20 years. Knowing that a dozen or so guys had beaten the market tells us, even if they share their investment style, nothing if we don’t observe results of dozens or hundreds of others who have tried to use the same strategy.

    But let’s accept that Warren Buffet’s performance is a result of systematic strategy exploiting market inefficiencies. So yes, EMH is falsified. Only problem is that almost nobody thinks EMH is literally 100% true (and that’s not epistemic relativism – it’s a realistic approach to complex scentific issues, as opposed to naive misunderstanding of falsification). The real question is how close is the market to efficiency? And the fact that large majority of active investors cannot beat passive strategies, let alone replicate succes of Buffet and a small group of others, indicates that inefficiencies are pretty small and hard to exploit.

    And by the way, far from being an uncritically accepted piece of ideology, EMH and related issues have been subject of immense amount of debate and empirical tests by economists, both its proponents and critics (and yes, that includes Buffet’s success [1]). It’s out there, available to read by anyone open-minded enough to look beyond simple slogans and anecdotes.


    • The theory used by the investors like Buffett assumes IRRATIONALITY on the part of the market participants. If they are making money using this theory it assumes that the EMH is wrong from first principles. The paper you link to does not appear to recognise this.

      Value investing holds not that market efficiency is “limited” but rather that the majority of investment is speculative. The assumptions are very close to Post-Keynesian ideas about financial markets. They also explicitly assume from the outset that the future is uncertain in the Keynesian/Knightian sense. Every version of the EMH shuns this assumption.

      Finally, the paper seems to refute the EMH.

  3. Anon says:

    Does your analysis change much, if at all, if you narrow your focus to the semi-strong version of the EMH, which posits all publicly available material information is incorporated into prices? This version appears to be the one most commonly advanced and accepts that one can beat the market with inside information.

  4. A Non y Mous says:

    1) It seems to me you are confounding different “definitions” of market efficiency. There is the Hayekian notion of markets (in general, not just financial ones) as information aggregators. Then there is the belief in the existence of a fundamental value, crucial to the “value investors” in the mold of Graham and Dodd. Some economists define market efficiency as the identity of price and (fundamental) value, while value investors base their strategy on the difference between them. Finally, there is the “theory-free” school following Fama who simply define efficiency as lack of predictability (by rules). There are probably other definitions around, all related for sure, but still different. A discussion or critique of “market efficiency” as an idea would benefit from being more clear, I think, of which aspect of which definition one criticizes.

    2) I’ve never understood the way in which you too seem to use the term “economists”. Are you not an “economist”? What is an “economist”? Is it not someone who thinks seriously about economic matters, where we understand “economic” to pertain to exchange of goods, i.e. a subfield of sociology? What is the difference between an “econophysicist” and an “economist”? Is the meaning of “economist” bound to a method and not to its subject? If so, I strongly disapprove of this usage. There are (and have always been) different “schools” of economists. What is different today that we should use “economist” as an insult?

    3) Related to the above, I think a critique would, again, benefit from more specificity. Who or rather which theory or which paper exactly are you criticizing? Is it Fama? Cochrane? Then it would be nice to actually have a summary of their position.

    I’m not necessarily disagreeing with your post, I just don’t think it’s quite “there” yet. 😉

    • (1) I don’t think that G&D overlap with Hayek. They imply that markets rarely allocate resources effectively.

      (2) I refer to the vast majority of people calling themselves “economists”. Am I one? Yes, I suppose so. I’m also Irish. But that does not stop me criticising the “Irish” when I think they, en masse, are wrong in their politics or their culture or whatever.

      (3) I had in mind Fama and Malkiel. They are my sources on the matter. I think they are Buffett’s too.

      • Dantey says:

        As an economics noob,

        1) “They imply that markets rarely allocate resources effectively.” – Isnt that something very serious, because as far as I understand it strikes at the heart of many ideologies used to organise society?

    • Dantey says:

      As an economics noob,

      1) Why even bother with using the word ‘efficient’ when in this case it so clearly creates vagueness and noisey discussions? It should be done away with. But I have a feeling that it would create a clarity too uncomfortable for many vested interests to handle.

  5. Shaun says:

    “It is also interesting that the investment strategy that Buffett, Keynes and the nine other investors discussed in Buffett’s article runs exactly contrary to the EMH assumption of information being priced into markets at all times. Indeed, their investment strategy rests on the idea that market prices often diverge substantially and for long periods of time from the underlying value of the assets.”

    In a world of fundamental uncertainty and animal spirits, does an underlying value even exist in equity markets?

    • That is an interesting question and one that I have been thinking about a lot over the past few days. I think it does though. Post-Keynesians believe that people behave in many situations in line with ‘bounded’ or ‘procedural’ rationality. That is, they lay down vague rules of thumb that they use for decision-making in an uncertain world. I think that the ‘reversion to mean’ in the theory of fundamental value is something like this. It is not so much that ‘true value’ exists but that there is a gravitation point around which speculative valuations swing.

      • Shaun says:

        Thanks for responding! Although your response led me to think about speculative bubbles and Minsky’s FIH, where the ‘reversion to mean’ seams to be “a little bit higher” until it all comes tumbling down.

  6. Ian says:

    I played with the markets for a bit. The understanding I settled on in regards to the way the market works was Richard Wykcoff’s work. I was wondering if I could get your opinion on his work.

  7. Dantey says:

    This brings another question to my mind that as an economics noob I have started to ponder about quite a bit.
    All this so called “investment” in the financial markets, doesnt this essentially boil down to people just gambling? Are there any people here who are actually contributing to society in a productive manner because the way I see it they are simply leeching off society? None of this activity, it seems, is geared towards taking society forward and towards prosperity of the many. In fact with the increasing penetration of the financial industry into every aspect of our lives it seems to be taking us in the opposite direction.

    @philip – I would love it if you could provide your more informed view on this via a comment or a blogpost geared towards providing an understanding to the general layman.

    • Mark says:

      Well, people who invest in IPOs and in bond offerings certainly contribute to society, since they allow companies to raise capital for various purposes. What happens once these stocks and bonds start trading on the market, well, that’s a different issue.

      • Dantey says:

        That might be one aspect of it. But I doubt a lot of them do it for the purpose of raising capital so that society may prosper from the workings of their invested companies. For example, from what I have read about silicon valley IPOs, many founders, their venture capital firms and finance people involved invest in the company so that they can simply sell it off later for a profit. They dont really have much of an intention to actually build a ‘sustainable’ business which can benefit society.

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  9. HENRY LEE says:

    Value Investing is Art
    EMH is Science
    Art is for a chosen few
    Science is for everybody

  10. david says:

    i’ve always railed against believers in EMH for three simple reasons. 1). Not everybody reviews all readily available information. 2). Not everyone processes that information the same way, and 3). Not everyone will make the same calls with that information.

    Many investors are prone to rumors when it comes to planning their investments, and so they rely on someone elses opinion to make their purchasing decisions.

    Also, if you are a technical (or the new term “Quantitative) analyst you will not be interpeting information the same way as a fundamental analyst.

    And even if you do hapoen to process the same information the same way it doesn’t guarantee a person will inevitably make the same decision.

    EMH depends on a fictional perfect investing world where every involved party plays their assigned roles in the exact same way in order to be true, but one doesn’t exist. It is my experience that most humans are irrational and lazy. If they can find an easier way, even if it’s not the better, then they’ll take. EMH gives people too much credit.

  11. Skippy says:

    Ooh… I made some mad with this – the EMH is a tautology which seeks validity by shaping its own reality

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