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Omo
Joined: 31 May 2008
Posts: 66
Location: Australia
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 Posted: Tue Nov 03, 2009 6:58 am Post subject: Efficient Markets Have Zero Returns |
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Can anyone dispel this argument from Jacob at earlyretirementextreme.com
http://earlyretirementextreme.....have-zero-
returns.html#comments |
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EmergDoc
Joined: 02 Mar 2007
Posts: 4938
Location: Home sweet home
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| Posted: Tue Nov 03, 2009 7:08 am Post subject: Re: Efficient Markets Have Zero Returns |
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Which of the false arguments would you like dispelled?
Should we start with the title?
| Quote: | Efficient markets have zero returns
Published on November 2nd, 2009
Posted by Jacob in Finance
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If markets were 100% efficient there would not be any trading. When new information was made available to the market, everybody would simply adjust their price expectations. Since trading happens, markets are not efficient.
The efficient market hypothesis can, therefore, easily be shown to be wrong. Yet it is still a good approximation which makes portfolio theory sufficiently mathematically tractable to write papers about it and win Nobel prizes, say.
Insofar efficient market theory is a close approximation of reality, the best trading strategy is not to trade at all (see paragraph 1). However, the more popular this becomes, the more difficult it becomes to estimate asset prices. Buy&Hold on a large scale, therefore, makes asset prices more volatile.
The more popular buy&hold becomes, the closer index returns will be to GDP growth, that is, around 3% in real growth. Any growth beyond this is rightfully attributed to investing becoming more popular, hence it is only possible to get the historic 10% returns, if you are actually part of the history where fewer people were equity investors |
So which is it? Indexing will give you zero returns or 10% returns? I'm not sure which to argue against.
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Rodc
Joined: 26 Jun 2007
Posts: 4463
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| Posted: Tue Nov 03, 2009 7:57 am Post subject: |
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| Quote: | | If markets were 100% efficient there would not be any trading. |
Money is always coming in to the market and leaving the market. I buy every time I get paid for example. Someone who needs more money than the dividends will have to sell. Just for some examples.
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The efficient market hypothesis can, therefore, easily be shown to be wrong. Yet it is still a good approximation... |
True of all models, though not for his reasons. Everyone knows that markets are not perfectly efficient, that is one reason why some people work so hard to find arbitrage opportunities, and that work is what keeps the markets more or less efficient. Yet, it is a good approximation, as he says, which is why it is so hard (but not impossible) to beat a simple buy and hold strategy. So, as an individual you only actively trade if you think you are smart enough to win the game of arbitrage (or other active motivation) against professionals who play full time and have access to a greater amount of data and more timely data than you do.
| Quote: |
Buy&Hold on a large scale, therefore, makes asset prices more volatile. |
Possibly true, but nowhere near that much money is tied up in index funds and buy and hold. As long as people like this guy exist, we are unlikely to get to that point.
| Quote: | | ... if large numbers of people are retiring, expect the markets to drop. |
That is a point worthy of discussion. My take is that the baby boomers don't actually hold that much of the market in retirement accounts, and they will bleed off what little they do hold over the course of 30 or more years (the boomer span a wide range of age and might on average have a 20 year retirement), and the ones with lots of money will pass a fair amount of that money to their kids and grand kids and so the stocks will stay invested. That is counter balanced by a smaller generation behind them, but one that will need to save more per capita as they will need to fully fund their own retirements and by the rising number of people in the investing class around the world. Not to mention this seems like a distinctly US (but not entirely unique to the US) issue, and all good investors diversify at least somewhat on a global scale.
All in all a poorly thought out piece.
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TheEternalVortex
Joined: 27 Feb 2007
Posts: 1290
Location: Ann Arbor, MI
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| Posted: Tue Nov 03, 2009 8:36 am Post subject: |
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| Quote: | | If markets were 100% efficient there would not be any trading. |
That is nonsensical. First, the EMH requires trading to make the market efficient. The market can't magically know the correct price without trading. The point of EMH is that the trading occurs so quickly and with such small inefficiencies that it's impossible for individual investors to take advantage of it. Also, I don't think anyone really believes the market is efficient w.r.t. private information. So trading would have to occur on that account as well.
And, as noted, there would be trading for non-investment reasons, such as selling equities to buy a house, or investing new money.
| Quote: | | The efficient market hypothesis can, therefore, easily be shown to be wrong. |
It's very hard to show weak-form EMH wrong. I don't think anyone seriously believes that strong-form EMH is right.
| Quote: | | ... if large numbers of people are retiring, expect the markets to drop. |
This would be priced into the market already, since it's a fairly obvious piece of information. |
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dmcmahon
Joined: 21 Mar 2008
Posts: 683
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| Posted: Tue Nov 03, 2009 4:33 pm Post subject: |
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The more popular buy&hold becomes, the closer index returns will be to GDP growth, that is, around 3% in real growth.
Points:
1. 3% is not zero. It's actually not a bad rate of return.
2. World GDP may grow faster than 3%. Investors don't have to limit themselves to the USA.
3. There's a hidden assumption that the only source of returns is growth in the value of the business due to GDP expansion. This ignores the returns being thrown off by the business. A business may return 7% even while GDP is growing at 0%. These returns may flow as dividends, or they may stay "in" the company - either way, the owners of the business get the return. |
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eurowizard
Joined: 10 May 2008
Posts: 844
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| Posted: Tue Nov 03, 2009 4:46 pm Post subject: |
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| I didn't read the article and no interest to, but one could argue that efficient markets have zero economic profit returns on a risk-adjusted basis. Meaning that if the risk-reward model is X then you will earn exactly X with is 0% above what you should earn considering risk. |
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dumbmoney
Joined: 16 Mar 2008
Posts: 1312
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| Posted: Tue Nov 03, 2009 6:26 pm Post subject: |
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| TheEternalVortex wrote: | | Quote: | | If markets were 100% efficient there would not be any trading. |
That is nonsensical. First, the EMH requires trading to make the market efficient. The market can't magically know the correct price without trading. |
The market can't magically know the correct price...period!
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Omo
Joined: 31 May 2008
Posts: 66
Location: Australia
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| Posted: Tue Nov 03, 2009 6:35 pm Post subject: |
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| Quote: | | ... if large numbers of people are retiring, expect the markets to drop. |
| Quote: | | That is a point worthy of discussion. My take is that the baby boomers don't actually hold that much of the market in retirement accounts, and they will bleed off what little they do hold over the course of 30 or more years (the boomer span a wide range of age and might on average have a 20 year retirement), and the ones with lots of money will pass a fair amount of that money to their kids and grand kids and so the stocks will stay invested. That is counter balanced by a smaller generation behind them, but one that will need to save more per capita as they will need to fully fund their own retirements and by the rising number of people in the investing class around the world. Not to mention this seems like a distinctly US (but not entirely unique to the US) issue, and all good investors diversify at least somewhat on a global scale. |
I think the latter is the main point that worries me.
If the investing public is demographically top heavy (ie more baby boomers than Gen X and Y's) then as the baby boomer generation sells to fund their retirement, there will be more supply of equities than demand for equities, thereby reducing the value of equities.
Is this a fair argument? |
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KyleAAA
Joined: 01 Jul 2009
Posts: 346
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| Posted: Tue Nov 03, 2009 6:55 pm Post subject: Re: Efficient Markets Have Zero Returns |
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If there were no trading, how would the market be efficient? That's a self-contradictory statement. |
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pkcrafter
Joined: 04 Mar 2007
Posts: 2300
Location: CA
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| Posted: Tue Nov 03, 2009 7:36 pm Post subject: |
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dumbmoney wrote:
| Quote: | | The market can't magically know the correct price...period! |
It is important to define "correct." The market will quickly set the price that the market consensus believes is the correct price. That does not mean fair value or anything else. Whatever the price, it includes forward looking estimations of earnings and other things.
The problem is if one investor thinks the price is wrong, it is very difficult for him to profit since he must trade with those who think the price is correct. In reality there are many on both sides of the price who think it is wrong: it's kind of like a tug of war between two equal groups. Using the same analogy, the market quickly balances the groups so they are equal and the rope doesn't move much.
Paul
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grabiner
Joined: 20 Feb 2007
Posts: 2798
Location: Columbia, MD
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| Posted: Tue Nov 03, 2009 9:06 pm Post subject: |
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| eurowizard wrote: | | I didn't read the article and no interest to, but one could argue that efficient markets have zero economic profit returns on a risk-adjusted basis. Meaning that if the risk-reward model is X then you will earn exactly X with is 0% above what you should earn considering risk. |
I would say this is true by definition. If the number of investors who demand a 5% risk premium to buy stocks rather than Treasury bills is equal to the supply of stocks, then the risk premium will be 5%. In a perfectly efficent market, the return of a portfolio with half the risk of stocks could not be more than 2.5% above the risk-free rate. (It can be less; you aren't compensated for taking diversifiable risk.)
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baw703916
Joined: 01 Apr 2007
Posts: 1834
Location: Northern Virginia
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| Posted: Tue Nov 03, 2009 10:51 pm Post subject: |
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| grabiner wrote: | | eurowizard wrote: | | I didn't read the article and no interest to, but one could argue that efficient markets have zero economic profit returns on a risk-adjusted basis. Meaning that if the risk-reward model is X then you will earn exactly X with is 0% above what you should earn considering risk. |
I would say this is true by definition. If the number of investors who demand a 5% risk premium to buy stocks rather than Treasury bills is equal to the supply of stocks, then the risk premium will be 5%. In a perfectly efficent market, the return of a portfolio with half the risk of stocks could not be more than 2.5% above the risk-free rate. (It can be less; you aren't compensated for taking diversifiable risk.) |
Yes. The problem is that there isn't an obvious way to do the risk adjustment, except by using the market price and assuming an efficient market.
Say for instance that the inflation rate is 1.0%, the interest rate on 3 month T-bills is 2.5%, the yield on TBM is 4.5%, and the dividend yield on TSM is 3%, with a rate of earnings growth of 4%. On a risk adjusted basis, which is the better deal? It's kind of hard to calculate the answer from first principles without making some assumptions or invoking market efficiency.
Brad
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spam
Joined: 10 Jun 2008
Posts: 643
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| Posted: Wed Nov 04, 2009 5:25 am Post subject: |
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Omo wrote
| Quote: | If the investing public is demographically top heavy (ie more baby boomers than Gen X and Y's) then as the baby boomer generation sells to fund their retirement, there will be more supply of equities than demand for equities, thereby reducing the value of equities.
Is this a fair argument? |
Not every investor lives in the USA, and not every person who lives in the USA buys securities. There are emerging middle classes in China and India that could easily offset the boomers impact.
Also, don't forget institutional investors. A larger risk might come from monitary policy or politics than demographics.
I think the argument is narrow. |
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