The other day I did a post on the Efficient Markets Hypothesis (EMH) that generated some discussion. I want to deal with a few of the issues raised in a some upcoming blogposts.
One issue of interest was that many EMH proponents said: “Sure, Warren Buffett and Keynes beat the market over a long-period we’re not saying that this is impossible. Some people might beat the market out of pure luck.” Well that seems like rubbish to me.
Think about this. If the EMH says that no one single person can beat the market over the long-run that is a testable proposition. But if they then say that some people might but this is “by luck” that is not testable. That is, in fact, based on an a priori assumption that anyone who beats the market did not do so by skill.
Now, personally I think that some people beat the market by skill. The fact that very few beat the market is not remotely surprising given this interpretation. Most market participants, by definition, will fall around the average and track the market over the long-run. Some really bad participants will fall way behind (these people would just be “unlucky” according to EMH Gospel, I’d be more inclined to say that they are bad at their jobs). And some people — not very many — will come out ahead.
The same is the case in anything. Most football players will be average. Some will be awful. Some will be top class. Is this “by luck”? Well, in terms of their genetic make-up and the environment they grew up in, it is in some sense. Our skills and talents are partially derived by us through what might be called “luck” or “chance”. But this is not what the EMH proponents mean. They mean that you cannot really apply skill to beat the market.
Personally I think that the EMH is a tautology masking as an argument. By definition the average investor cannot beat the market (which is the average outcome of investor decisions). Just like the average runner in a race cannot beat the average outcome of the race. But particular investors may well beat the market. The EMH says that this is not through skill but due to luck. That is not really a testable proposition. And it seems unlikely if we look at the real world.
If we look at the people who consistently beat the market they seem like very hard-working individuals who know the markets intimately and have very well-developed ideas about how to invest. I don’t see any charlatans amongst these. Nor do I see monkeys throwing darts at the stock indices. This leads me to conclude that these people got there by hard work and ingenuity. The onus should be on EMH proponents to produce dart-throwing monkeys that get the returns of Warren Buffett. My sense is that the laws of probability will not allow this any more than they will allow — in the real world — a monkey with a typewriter to produce the works of Shakespeare.
The EMH proponents want us to basically think that there is no skill involved when people beat the market. But again, this is an a priori assumption. They only think this because they assume it. When we look at the real world it appears unlikely. As I wrote in the last post: is it just a coincidence that one of the most important financial economists of the 20th century just “got lucky” and beat the market in the 1930s? The odds of a person being both one of the major financial economists of the 20th century and one of the few people to beat the market in the 1930s strike me as very low. But they need not be if we assume that there might be a link between Keynes being a brilliant financial economist and a brilliant investor.
So, we have established that this assumption by the EMH proponents is a priori. It has the status not of science — it is not testable — but of dogma. Why then is it held? I think that there is a very simple psychological/sociological reason for this that is actually quite obvious when you think about it.
People who teach the EMH claim to be experts on financial markets. They claim to have knowledge of how the markets work that is objectively correct. Now, this is slippery game indeed. Why? Because if someone jumps up and says “I am an expert on the financial markets and I know how they work” society as a whole can reply “Okay then, go and use this knowledge to play the markets and win”.
This causes a huge problem for financial economists. But if they say that their expertise on the financial markets tell them that anyone who beats the market only does so by luck then they are insulated. They can still claim to be experts while at the same time never having to prove their expertise because their expertise now needs no proof. It is a bit like me walking around saying that I am the best driver of flying cars in the world. Then when people tell me to prove it I turn around and say “Why of course I cannot prove it… everyone knows that flying cars don’t exist!”.
Well, that is all very well and good. Perhaps I can trick some gullible people into believing that I am indeed the best driver of flying cars in the world. That will not do much harm. Unfortunately, these “financial market experts” get into positions where they are allowed to dictate how financial markets are regulated. That will tend to cause enormous problems should I be right and should these people be largely engaged in sophistry.