Does EMH hold water?

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Does EMH hold water?

Postby larryswedroe » Thu Jul 11, 2013 8:34 am

My thoughts on piece by Motley fool on this issue

Hope you find it helpful http://www.cbsnews.com/8301-505123_162-57592893/beware-bad-financial-journalism/
Best wishes
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Re: Does EMH hold water?

Postby tadamsmar » Thu Jul 11, 2013 8:49 am

The author did offer one important takeaway: "Warren Buffett would have not been successful in the stock market if EMH was entirely true. He quipped once: 'I'd be a bum on the street with a tin cup if the markets were always efficient.' ''


If the markets were efficient, there would be some fabulously wealthy speculators and some speculators that end up as bums on the street with a tin cup. So, even if Buffet was pure stock market speculator in an efficient market, it would not be a sure thing that he ended up a bum. (And, he seems to be at least part business manager, but perhaps his early investments were more speculative.)
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Re: Does EMH hold water?

Postby richard » Thu Jul 11, 2013 9:12 am

One of the main problems with the EMH is how to test it. For those who believe it's true, what would convince you it's false?

The article includes "Are active investors able to persistently exploit anomalies (mispricings) after all costs?" Active investors as a group can't persistently exploit anomalies, whether or not EMH holds. Active investors are the market (passive investors mirror their aggregate performance). Absent a strong Lake Wobegon effect, the market can't beat itself.

Similarly, we have Warren Buffett's track record. There are some investors who persistently beat the market. Is there a point at which we believe they have talent rather than luck? As far as I can tell, we don't have enough data to answer that question and we will never have enough data. For example, we'd likely need many managers to work for times much longer than the human lifespan to have enough data. (The article links to a paper that seems to be on this subject, but the link is broken)

I completely agree with the conclusion: "If the author was suggesting that you should try to pick stocks or winning fund managers because markets are inefficient, the evidence demonstrates that following that advice makes you highly likely to underperform appropriate risk-adjusted returns."

Even if there are talented market beating investors, why would you think you could identify them and why would you think they wouldn't charge enough to compensate them fully for their talents?
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Re: Does EMH hold water?

Postby bobbun » Thu Jul 11, 2013 10:28 am

I have never understood why people use Buffett as the test case here. His company often owns the businesses it purchases outright. Can an active business manager outperform a passive securities investment approach? It's an apples to oranges comparison that I don't think EMH can be applied to.
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Re: Does EMH hold water?

Postby FafnerMorell » Thu Jul 11, 2013 11:00 am

I've found a good rule of thumb is to never trust financial journalism that uses Warren Buffet as the primary (and generally only) example - if folks could achieve the same results as WB did by reading a "How to Invest like Warren Buffet" book/article, we'd have about five million multi-billionaires (in the $50 billion range) - and it would be great to see the GDP increase by $250 trillion. Since we don't see an $250 trillion or so in the economy, it's obvious these books/articles don't deliver the results that their titles imply. (Also, why no books on how to invest like Slim Carlos? or how to write code like Bill Gates?)

Another good rule of thumb is "Cui Bono" - when they're proposing/refuting a theory, it generally has the subcontext "Because X is true/false, you should give me your money to invest". Just about every article I've seen attacking EMH has someone pushing their "You can beat the market by giving me money" agenda (whereas if their scheme really worked, why not just use it - after all, if they made their own $50 billion with it, they wouldn't need to stowaway a ride on Warren's reputation.
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Re: Does EMH hold water?

Postby dodonnell » Thu Jul 11, 2013 11:33 am

Theoretically, for EMH to hold, does it require the participation of at least some active investors ?
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Re: Does EMH hold water?

Postby Phineas J. Whoopee » Thu Jul 11, 2013 12:17 pm

dodonnell wrote:Theoretically, for EMH to hold, does it require the participation of at least some active investors ?

Yes.

The active investors contribute to the price discovery process. So do all the indexed but tilted, and "indexed" but using something other than cap weight investors.

As noted by other posters in previous threads it takes surprisingly few active market participants to make price discovery efficient.

If there were so few non cap-weight-total-market-indexers that prices became clearly inappropriate, enough of the rest would give up indexing and go to active strategies thereby: a) collecting their due as arbitrageurs; and b) restoring the price discovery mechanism, which would reduce arbitrage opportunities.

The opportunities would fluctuate around an equilibrium, perhaps with a continuation of the technological race which consumes arbitrageurs today.

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Re: Does EMH hold water?

Postby Call_Me_Op » Thu Jul 11, 2013 12:29 pm

FafnerMorell wrote:I've found a good rule of thumb is to never trust financial journalism that uses Warren Buffet as the primary (and generally only) example - if folks could achieve the same results as WB did by reading a "How to Invest like Warren Buffet" book/article, we'd have about five million multi-billionaires (in the $50 billion range) - and it would be great to see the GDP increase by $250 trillion.


Your math is a bit off. 5 million times 50 billion is $250,000 trillion, or $250 quadrillion.
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Re: Does EMH hold water?

Postby garlandwhizzer » Thu Jul 11, 2013 12:34 pm

I do not believe that the market always prices securities with perfect efficiency. I do believe that it prices securities more efficiently than the average investor or the average active fund manager. I don't believe that it's perfect but I do believe that its imperfections are the exception rather than the rule, and that as Larry says, where is the evidence that active managers can exploit these imperfections on a consistent basis?

One additional point. As Bogle says whether the market is efficient or not, the CMH (Cost Matters Hypothesis) is totally reliable all the time. I have for many years tried to outperform TSM and other broad indexes with stock selection, active management, etc., and the longer I try, the more I realize just how solidly and effectively inexpensive broadly based indexes perform. As the years pass, more and more of my portfolio gravitates toward TSM and TISM with some small cap indexes tossed in as well.

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Re: Does EMH hold water?

Postby tadamsmar » Fri Jul 12, 2013 9:50 am

In reference to bubbles:

"Are active investors able to persistently exploit anomalies (mispricings) after all costs?"


I am not sure bubbles should be referred to as mispricing. The fact that a stock had a different price yesterday does not imply a mispricing. I that is true, then we are saying that the only prices that are not amiss are those that stand up to 20-20 hindsight.
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Re: Does EMH hold water?

Postby M1garand30064 » Fri Jul 12, 2013 10:46 am

I just finished Nate Silver's book "The Signal and the Noise" and it had an excellent chapter examining EMH and behavioral finance. The conclusions he reached about bubbles, their persistence, and why it is so hard to profit off of them were excellent in my opinion.

The phrase "The market can remain irrational longer than you can remain solvent" certainly holds true.
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Re: Does EMH hold water?

Postby tadamsmar » Sun Jul 14, 2013 6:09 am

M1garand30064 wrote:I just finished Nate Silver's book "The Signal and the Noise" and it had an excellent chapter examining EMH and behavioral finance. The conclusions he reached about bubbles, their persistence, and why it is so hard to profit off of them were excellent in my opinion.

The phrase "The market can remain irrational longer than you can remain solvent" certainly holds true.


Since bubbles are always identified by hindsight, a persistent bubble could be indistinguishable from a retirement plan that panned out well for the heirs.
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Re: Does EMH hold water?

Postby IlliniDave » Sun Jul 14, 2013 7:04 am

I view the market as efficiently manifesting the opinion of it's participants. It's participants are human and thus prone to err, so things like bubbles occur.

The efficiency affects speculators most strongly, because speculation depends on prices set by prevailing opinion of active participants in the near-term.

I believe the "market efficiency" applies less strongly to the long term. In part it's because the majority of market activity is geared towards the short-term, so the threshing occurs in the realm of today's P/E. In general the active "mob" is impatient and not interested in getting an extra 1% a year over a 30-year commitment. They want to double their money in a year.

That seems like a logical source of disconnect. If your strategy differs from that of the people doing the overwhelming majority of the trading, there are probably modest opportunities to be exploited--things like small and value premiums (when combined with a patience premium).

A lot of poor strawmen get pummeled in the EMT debate from what I've seen.
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Re: Does EMH hold water?

Postby nedsaid » Sun Jul 14, 2013 10:55 am

Warren Buffett was successful for a number of reasons. He is a very bright guy and has a great temperment. Steady as she goes and he doesn't get caught up in the manic depressive emotions of the market. He also had a consistent approach to investing that he refined but didn't fundamentally change. He also had an excellent partner in Charlie Munger. As he bought companies outright, he didn't interfere with the excellent managements that these companies had. He didn't try to micromanage everything. Mr. Buffett was and is a very good businessman.

What he did with Berkshire-Hathaways stock portfolio was really only part of the success of that company. He did some trading but he had a few core holdings like American Express, Wells Fargo, Coca-Cola, and Washington Post that accounted for most of his success in stock picking.

I also like the way he viewed stock picking. One buys stocks as if he is buying the entire company.

Buffett wasn't "lucky." But folks like him don't come around very often. Most that try to copy his technique don't have his success.

The evidence that the markets are efficient is pretty compelling. I read Peter Lynch's books on stock picking but I never got his results. These people were the exception to the rule. Timing is a big part of this two. Peter Lynch came along at a time the public had lost interest in stocks and after a long period during which stocks didn't do well.

The people around Mr. Buffett including his shareholders were very patient. He built a terrific reputation early on. The markets are so short term oriented that someone trying to copy Mr. Buffett's style would be fired before the strategies could work. Most folks are not into patience now a days. They want outperformance and they want it now.
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Re: Does EMH hold water?

Postby Phineas J. Whoopee » Sun Jul 14, 2013 12:03 pm

IlliniDave wrote:I view the market as efficiently manifesting the opinion of it's participants. It's participants are human and thus prone to err, so things like bubbles occur.

The efficiency affects speculators most strongly, because speculation depends on prices set by prevailing opinion of active participants in the near-term.

I believe the "market efficiency" applies less strongly to the long term. In part it's because the majority of market activity is geared towards the short-term, so the threshing occurs in the realm of today's P/E. In general the active "mob" is impatient and not interested in getting an extra 1% a year over a 30-year commitment. They want to double their money in a year.

That seems like a logical source of disconnect. If your strategy differs from that of the people doing the overwhelming majority of the trading, there are probably modest opportunities to be exploited--things like small and value premiums (when combined with a patience premium).

A lot of poor strawmen get pummeled in the EMT debate from what I've seen.

Hi IlliniDave,

In general I think your posts are well-informed and interesting, but I'm puzzled by this one.

The efficient market hypothesis relates to the pricing-in of information. It says nothing about the short- or long-term, nor about opinions.

Are you able to unpuzzle me? Are you talking about behavioral economics, which is not inconsistent with the EMH?

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Re: Does EMH hold water?

Postby IlliniDave » Sun Jul 14, 2013 12:52 pm

Phineas J. Whoopee wrote:
IlliniDave wrote:I view the market as efficiently manifesting the opinion of it's participants. It's participants are human and thus prone to err, so things like bubbles occur.

The efficiency affects speculators most strongly, because speculation depends on prices set by prevailing opinion of active participants in the near-term.

I believe the "market efficiency" applies less strongly to the long term. In part it's because the majority of market activity is geared towards the short-term, so the threshing occurs in the realm of today's P/E. In general the active "mob" is impatient and not interested in getting an extra 1% a year over a 30-year commitment. They want to double their money in a year.

That seems like a logical source of disconnect. If your strategy differs from that of the people doing the overwhelming majority of the trading, there are probably modest opportunities to be exploited--things like small and value premiums (when combined with a patience premium).

A lot of poor strawmen get pummeled in the EMT debate from what I've seen.

Hi IlliniDave,

In general I think your posts are well-informed and interesting, but I'm puzzled by this one.

The efficient market hypothesis relates to the pricing-in of information. It says nothing about the short- or long-term, nor about opinions.

Are you able to unpuzzle me? Are you talking about behavioral economics, which is not inconsistent with the EMH?

PJW



Probably I can't unconfuse you, PJW, sorry. I have a tendency to look at things in odd ways. I guess in a sense I'm mixing behavioral economics and EMH, because the market is a human endeavor. The information is brought in, interpreted, and acted upon by humans. Much of the information is generated by humans (especially when it's forward-looking). So to me it's unnatural to separate the two. Most of it is brought to bear and acted upon in a short-term context because most of the trading is done by people that trade stocks with a short-term outlook. So that group of people as a collective very quickly digests that information from their perspective and stocks prices react apparently in a matter of seconds to "new" information (in the news recently we saw people paying something like a million dollars for a 2-second head start on an economics report).

Efficiency is always in a context. The most "efficient" engine for hauling freight across the country is not the most efficient engine for a family car or for a state police cruiser. When people talk about EMH I picture an engine optimized for what people are going to buy or sell for in a matter of days or weeks. "Renters" I've heard them called. That leaves room for people who think in terms of decades opportunities like so-called value stocks.
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Re: Does EMH hold water?

Postby Phineas J. Whoopee » Sun Jul 14, 2013 1:13 pm

IlliniDave wrote:...
So that group of people as a collective very quickly digests that information from their perspective and stocks prices react apparently in a matter of seconds to "new" information (in the news recently we saw people paying something like a million dollars for a 2-second head start on an economics report).
...

[Emphasis added.]

Fair enough about looking at things differently. I'm responding for just one quibble. I believe the money spent is not to buy a 2-second advantage regarding a single economics report, but for a year-long subscription to 2-second early data. Not that I'm happy with it, mind everyone, but to the extent it's possible for me I like to stay accurate.

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Re: Does EMH hold water?

Postby LadyGeek » Sun Jul 14, 2013 1:27 pm

This thread is on the journalism aspects. For those who want to deep-dive into EMH a bit further: Does this mean I don't believe in the efficient market theory
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Re: Does EMH hold water?

Postby IlliniDave » Mon Jul 15, 2013 7:27 am

Phineas J. Whoopee wrote:
IlliniDave wrote:...
So that group of people as a collective very quickly digests that information from their perspective and stocks prices react apparently in a matter of seconds to "new" information (in the news recently we saw people paying something like a million dollars for a 2-second head start on an economics report).
...

[Emphasis added.]

Fair enough about looking at things differently. I'm responding for just one quibble. I believe the money spent is not to buy a 2-second advantage regarding a single economics report, but for a year-long subscription to 2-second early data. Not that I'm happy with it, mind everyone, but to the extent it's possible for me I like to stay accurate.

PJW


Thanks, PJW, it was just something I heard in passing. Now I know a bit more about it. Still, hard to get my mind around why 2 seconds is that valuable.

I'm not an economist, financier, or any related discipline. But in my line of work we deal with reasonably complex stochastic systems with a certain amount of human interaction. So as I educate myself about investing and related things I tend to frame the ideas consistent with the manner of thinking I've habituated myself to. It probably lends itself to a certain amount of irreverence (which is unintentional). I am a firm believer in examining things from as many perspectives as possible, so when faced with "competing" notions like EMH versus behavioral finance my instinct is to go first to where respectively they have an apparent validity and see if there's some way they can work together rather than getting caught up on where they appear to disagree. The more dimensions a "problem" has the more apparent conflicts there are when you view things from the various subsets of those dimensions.
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Re: Does EMH hold water?

Postby staythecourse » Mon Jul 15, 2013 9:34 am

I will repeat what I always do when these EMH arguments come and that is WHO CARES!!

The question for the individual investor is NOT does the EMH true or not, but if it is not true is it actionable. Folks love to debate EMH as if they are academic and publishing an article on its validity with proofs and equations.

The only question the individual investor should care about is it is efficient enough not to make a profit post tax and post fees over a 25- 50 yr. time horizon? My answer to that would still be no so who cares??

Good luck.
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Re: Does EMH hold water?

Postby tadamsmar » Mon Jul 15, 2013 9:43 am

staythecourse wrote:I will repeat what I always do when these EMH arguments come and that is WHO CARES!!

The question for the individual investor is NOT does the EMH true or not, but if it is not true is it actionable. Folks love to debate EMH as if they are academic and publishing an article on its validity with proofs and equations.

The only question the individual investor should care about is it is efficient enough not to make a profit post tax and post fees over a 25- 50 yr. time horizon? My answer to that would still be no so who cares??

Good luck.


Just for the sake of argument...

When the SP500 PE gets above 40, many investors care whether this is a fair price at which to continue to hold or a very good time-limited opportunity to sell at a high price. If the EMH is true, it's (by some definitions at least) a fair price. That's who cares. And, selling above PE=40 could make enough difference to have long term implications for the investor over the investors remaining life span, given that average PEs are half that.
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Re: Does EMH hold water?

Postby Phineas J. Whoopee » Mon Jul 15, 2013 2:50 pm

tadamsmar wrote:Just for the sake of argument...

When the SP500 PE gets above 40, many investors care whether this is a fair price at which to continue to hold or a very good time-limited opportunity to sell at a high price. If the EMH is true, it's (by some definitions at least) a fair price. That's who cares. And, selling above PE=40 could make enough difference to have long term implications for the investor over the investors remaining life span, given that average PEs are half that.

I hope I'm just biting, not arguing:

There's the efficient market hypothesis, in its weak, semi-strong, and strong forms, elucidated by (now) Dr. Fama (it was his PhD dissertation, so he wasn't Dr. Fama when he wrote it, but was upon its successful defense), which addresses informational efficiency. In your example, the PE being 40 is known by everybody, so no one can exploit it to beat somebody else.

Then there are innumerable mischaracterizations of it which are used by charlatans to convince their victims it can't possibly be true.

There are no valid variant definitions. There only untruths told intentionally for the purpose of enriching the teller at the expense of the hearer.

Whether you personally want to buy stocks if the S&P 500 average P/E is over 40 is of course up to you. If you want to sell yours under those conditions, you are dependent on somebody else wanting to buy in the same circumstances.

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Re: Does EMH hold water?

Postby tadamsmar » Mon Jul 15, 2013 4:30 pm

Phineas J. Whoopee wrote:
tadamsmar wrote:Just for the sake of argument...

When the SP500 PE gets above 40, many investors care whether this is a fair price at which to continue to hold or a very good time-limited opportunity to sell at a high price. If the EMH is true, it's (by some definitions at least) a fair price. That's who cares. And, selling above PE=40 could make enough difference to have long term implications for the investor over the investors remaining life span, given that average PEs are half that.

I hope I'm just biting, not arguing:

There's the efficient market hypothesis, in its weak, semi-strong, and strong forms, elucidated by (now) Dr. Fama (it was his PhD dissertation, so he wasn't Dr. Fama when he wrote it, but was upon its successful defense), which addresses informational efficiency. In your example, the PE being 40 is known by everybody, so no one can exploit it to beat somebody else.


I my view, you just explained why someone would care if the EMH is true or false. If the EMH is true an total market investor cannot sell at PE=40 to beat an investor who stays the course. If the EMH is false, the investor can beat the one who holds.

But, Fama actually says (more or less) that the EMH is ambiguous, you can accept the 3-factor model rather than the total market-model and still believe in the EMH relative to the model you choose to believe.
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Re: Does EMH hold water?

Postby Phineas J. Whoopee » Mon Jul 15, 2013 5:30 pm

tadamsmar wrote:
Phineas J. Whoopee wrote:
tadamsmar wrote:Just for the sake of argument...

When the SP500 PE gets above 40, many investors care whether this is a fair price at which to continue to hold or a very good time-limited opportunity to sell at a high price. If the EMH is true, it's (by some definitions at least) a fair price. That's who cares. And, selling above PE=40 could make enough difference to have long term implications for the investor over the investors remaining life span, given that average PEs are half that.

I hope I'm just biting, not arguing:

There's the efficient market hypothesis, in its weak, semi-strong, and strong forms, elucidated by (now) Dr. Fama (it was his PhD dissertation, so he wasn't Dr. Fama when he wrote it, but was upon its successful defense), which addresses informational efficiency. In your example, the PE being 40 is known by everybody, so no one can exploit it to beat somebody else.


I my view, you just explained why someone would care if the EMH is true or false. If the EMH is true an total market investor cannot sell at PE=40 to beat an investor who stays the course. If the EMH is false, the investor can beat the one who holds.

But, Fama actually says (more or less) that the EMH is ambiguous, you can accept the 3-factor model rather than the total market-model and still believe in the EMH relative to the model you choose to believe.

Hi tadamsmar,

That's not at all what I'm saying. I'm saying that the mis-view of the EMH which says all prices are appropriate at all times is false. I'm saying it's a mischaracterization of the hypothesis, intentionally promulgated for the purpose of cheating people.

The EMH, in its weak sense, says all investors have already taken into account all publicly-available information. How can that be false?

In its semi-strong sense, it says new publicly-available information is immediately incorporated into prices. One can dither over the meaning of the word immediately, and of course everything takes at least a little while, but given enough time for the new information to propagate, who could say it was false?

In its strong sense, it says even insider-only information is immediately incorporated into prices. Who claims the strong sense is true? Certainly not Dr. Fama.

The EMH does not say all prices are always perfect. It only says all prices account for all publicly-available information.

If I've not made my view clear, and I don't expect you to simply roll over and accept it, just to understand what I'm saying, then please let me know and I'll try again.

PJW
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Re: Does EMH hold water?

Postby WhyNotUs » Mon Jul 15, 2013 9:03 pm

Phineas J. Whoopee wrote:
tadamsmar wrote:
Phineas J. Whoopee wrote:
tadamsmar wrote:The EMH, in its weak sense, says all investors have already taken into account all publicly-available information. How can that be false?
PJW


Momentum stocks (remember .com IPOs) and dogs might be examples of stocks not priced based on publicly-available info.

I am agnostic about EMH and its different forms. Algorithms trading with algorithms and trying to trigger surges or dumping by other algorithms making up the majority of daily trading, firms buying property close to NYSE servers in order to gain millisecond trading advantages, increasing focus on leverage and short term value, and firms paying for information seconds prior to public release are realities not just hypothesis and have convinced me that a new perspective is required to view the market rather reframing/rehashing old market theories (whether from the 30's or the 80's)

Since I am not interested enough in the market to try to conceptualize that new order, I just surrender to the index (and its diversification and low cost strategy) until/unless something better comes along. I do not have the tools or desire to be a predator and thus am prey. Thus far it appears that sticking to the "herd" of the indexes makes one less likely to be eaten.
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Re: Does EMH hold water?

Postby tadamsmar » Tue Jul 16, 2013 9:17 am

Phineas J. Whoopee wrote:The EMH, in its weak sense, says all investors have already taken into account all publicly-available information. How can that be false?


Not sure why you would ask that. It's false if investors have not taken into account all the publicly available information.
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Re: Does EMH hold water?

Postby Phineas J. Whoopee » Thu Jul 18, 2013 5:59 pm

tadamsmar wrote:
Phineas J. Whoopee wrote:The EMH, in its weak sense, says all investors have already taken into account all publicly-available information. How can that be false?


Not sure why you would ask that. It's false if investors have not taken into account all the publicly available information.

It was a rhetorical question.

Anyhow, the question isn't whether they've taken the information into account to your satisfaction, but whether they've done so to theirs. People who ignore all of it are part of the latter set.

I don't want to mislead anyone with another rhetorical question. Instead I'll just assert every investor is a member of the set of investors who have taken all publicly-available information into account to their satisfaction.

I invite refutations.

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Re: Does EMH hold water?

Postby WhyNotUs » Thu Jul 18, 2013 7:00 pm

Phineas J. Whoopee wrote:
tadamsmar wrote:
Phineas J. Whoopee wrote:The EMH, in its weak sense, says all investors have already taken into account all publicly-available information. How can that be false?

Instead I'll just assert every investor is a member of the set of investors who have taken all publicly-available information into account to their satisfaction.

I invite refutations.

PJW


Won't get one from me, as stated it is either a tautology or a circle too small to be interesting.
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Re: Does EMH hold water?

Postby zeugmite » Thu Jul 18, 2013 10:25 pm

Every so often EMH gets discussed and the same things repeated.

Here is a more in-depth discussion from three years ago, specifically on the relationship of bubbles to EMH:
http://www.bogleheads.org/forum/viewtopic.php?f=10&t=56956
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