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ObliviousInvestor
Joined: 17 Mar 2009
Posts: 150
Location: Chicago
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 Posted: Wed Nov 04, 2009 3:05 pm Post subject: Fama responds to Fox's "Myth of the Rational Market&quo |
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I don't know how I didn't find out about this until today, but Fama and French apparently have a blog (hosted by DFA).
Today's post is an interesting read in which Fama replies to Justin Fox's popular book The Myth of the Rational Market.
http://www.dimensional.com/fam....lprit.html
A quote:
| Quote: | | "The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don't believe markets are efficient." |
Enjoy. 
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Oblivious Investing: Building wealth by ignoring the noise. |
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superlight
Joined: 31 Mar 2008
Posts: 1033
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| Posted: Wed Nov 04, 2009 3:18 pm Post subject: |
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It wouldn't surprise me if most professional managers were conflicted, using VaR models based on random walk models based on efficient market models, while at the same time not believing in efficient markets. That would be a problem.
FWIW, Fama's final paragraph makes me angrier than it probably should (I'm a stickler for logical consistency):
| Quote: | | Toward the end of the book, Fox concludes that passive investing is the right choice for almost all investors. My academic friends in behavioral finance (for example, Richard Thaler) almost always end up with a similar conclusion. In my view, this is an admission that the EMH provides a good view of the world for almost all practical purposes. At which point, I say I won. |
No Doctor, if your hypothesis is worth anything, it should be about causality. You should have evidence that markets are "efficient" and that prices really do "reflect all available information." Saying that the behaviorists arrive the same conclusion by a totally different path does not support you.
It is a punt.
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ddb
Joined: 26 Feb 2007
Posts: 3105
Location: Manhattan
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| Posted: Wed Nov 04, 2009 3:19 pm Post subject: |
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| Eugene Fama wrote: | | Toward the end of the book, Fox concludes that passive investing is the right choice for almost all investors. My academic friends in behavioral finance (for example, Richard Thaler) almost always end up with a similar conclusion. |
Dr. Fama is apparently unaware that Richard Thaler is a partner in the firm Fuller & Thaler Asset Management, which has the following written right on its home page:
| Fuller and Thaler wrote: | | Investors make mental mistakes that can cause stocks to be mispriced. Fuller & Thaler’s objective is to use our understanding of human decision making to find these mispriced stocks and earn superior returns. |
In other words, securities are mispriced, and they can identify and exploit the price anomalies.
- DDB
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superlight
Joined: 31 Mar 2008
Posts: 1033
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| Posted: Wed Nov 04, 2009 3:27 pm Post subject: |
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BTW, I finished Fox's book, skimming the last couple chapters. It was good, but a bit of a drudge, just because it was such a thorough history of theories and models and their authors.
From my reading, a random walk, or random-seeming walk and the idea that prediction is hard, is very old in the markets. To me, pedantic logician that I am, the addition from EMH that mattered was the informational claim. That is that the random walk was attributable to informational efficiency, that old information had been incorporated, and that it took new information to move stocks.
That informational hypothesis has taken a lot of hits.
As I've said before, I'm annoyed that Fama can stand with a fall-back to "weak" EMH which is just the original observation again.
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Lbill
Joined: 13 Mar 2008
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| Posted: Wed Nov 04, 2009 3:31 pm Post subject: |
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Thanks for the link. Where Fama goes wrong IMO is his assumption that active investment comprises 80% of the institutional stake in the stock market:
| Quote: | | For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. |
I don't believe that. The overwhelming majority of managed funds are "closet indexers." Their returns are largely explained by their benchmark equity index. This is because fund managers can't afford to underperform their benchmark index, or they are out looking for a job. I think that a much smaller percentage than 80% actually represents true active management devoid of closet indexing. I'd like to see the aggregate results for that group. If they tend to do better than the "market" it would challenge EMH.
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bob90245
Joined: 19 Feb 2007
Posts: 3369
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| Posted: Wed Nov 04, 2009 3:43 pm Post subject: |
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| ddb wrote: | Dr. Fama is apparently unaware that Richard Thaler is a partner in the firm Fuller & Thaler Asset Management, which has the following written right on its home page:
| Fuller and Thaler wrote: | | Investors make mental mistakes that can cause stocks to be mispriced. Fuller & Thaler’s objective is to use our understanding of human decision making to find these mispriced stocks and earn superior returns. |
In other words, securities are mispriced, and they can identify and exploit the price anomalies. |
Just goes to show that even learned professors, who should know better, are blind to overconfidence and other investor behavioral foibles. 
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superlight
Joined: 31 Mar 2008
Posts: 1033
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| Posted: Wed Nov 04, 2009 3:47 pm Post subject: |
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| Quote: | | If they tend to do better than the "market" it would challenge EMH. |
I may be stating the obvious ... but I've got 5 minutes and a computer keyboard:
This is true. Successful prediction would challenge EMH. We can also think of other causations which would explain why "prediction is hard" though. Keynes' beauty contest model, for instance, also explains that.
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tadamsmar
Joined: 07 May 2007
Posts: 1917
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| Posted: Thu Nov 05, 2009 8:15 am Post subject: |
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| superlight wrote: | It wouldn't surprise me if most professional managers were conflicted, using VaR models based on random walk models based on efficient market models, while at the same time not believing in efficient markets. That would be a problem.
FWIW, Fama's final paragraph makes me angrier than it probably should (I'm a stickler for logical consistency):
| Quote: | | Toward the end of the book, Fox concludes that passive investing is the right choice for almost all investors. My academic friends in behavioral finance (for example, Richard Thaler) almost always end up with a similar conclusion. In my view, this is an admission that the EMH provides a good view of the world for almost all practical purposes. At which point, I say I won. |
No Doctor, if your hypothesis is worth anything, it should be about causality. You should have evidence that markets are "efficient" and that prices really do "reflect all available information." Saying that the behaviorists arrive the same conclusion by a totally different path does not support you.
It is a punt. |
Where you been?
The causality mechanism was described 109 years ago. |
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tadamsmar
Joined: 07 May 2007
Posts: 1917
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| Posted: Thu Nov 05, 2009 8:31 am Post subject: |
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[quote="ddb"] | Eugene Fama wrote: |
Dr. Fama is apparently unaware that Richard Thaler is a partner in the firm Fuller & Thaler Asset Management, which has the following written right on its home page:
| Fuller and Thaler wrote: | | Investors make mental mistakes that can cause stocks to be mispriced. Fuller & Thaler’s objective is to use our understanding of human decision making to find these mispriced stocks and earn superior returns. |
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This just set off my illogic detector. Can you substitute a more exact phrase for for the word "Investors"? The logic appears to work because one (without out thinking) tends to substitute the phrase "All investors", but that makes the statement false, inconsistent with the fact that Thaler is an investor. Substituting "Some investors" makes it plausible, but then the conclusion no longer follows, or at least fails to stand on its own.
Thaler and his clients are investors, but, if you believe Thaler, they are negating these pricing mistakes. Does he think he is the only one doing this? Does he have some evidence that investors like him are so rare that the there can be a significant error to be exploited. |
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tadamsmar
Joined: 07 May 2007
Posts: 1917
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| Posted: Thu Nov 05, 2009 9:01 am Post subject: |
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| superlight wrote: | BTW, I finished Fox's book, skimming the last couple chapters. It was good, but a bit of a drudge, just because it was such a thorough history of theories and models and their authors.
From my reading, a random walk, or random-seeming walk and the idea that prediction is hard, is very old in the markets. To me, pedantic logician that I am, the addition from EMH that mattered was the informational claim. That is that the random walk was attributable to informational efficiency, that old information had been incorporated, and that it took new information to move stocks.
That informational hypothesis has taken a lot of hits.
As I've said before, I'm annoyed that Fama can stand with a fall-back to "weak" EMH which is just the original observation again. |
The notion that prices incorporate all information available to traders was put forward 100+ years before Fama by Jules Regnault in 1853. Fama and others have explored this territory more systematically, but it was not a new idea.
Bachelier connected the informational efficiency of prices to the random walk back in 1900. But he did not use the term informational efficiency.
Search for the term "true price" in this book:
http://books.google.com/books?....navlinks_s
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superlight
Joined: 31 Mar 2008
Posts: 1033
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| Posted: Thu Nov 05, 2009 9:25 am Post subject: |
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I do have Regnault somewhere in the back of my mind. Someone, perhaps you, mentioned him here before. He might also have been mentioned in Fox's book, though his history is very US-centric.
For my money, the random-seeming walk and the great difficulty we have predicting markets are partially about rapid information dissemination. Certainly information flows and moves prices. It's not smooth though. Old information may suddenly "register" in fads and waves through social networks.
It can be analogous to butterfly wings and chaos theory, right? What starts a sell-off? A trader in Singapore needs a new Jag.
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hafis50
Joined: 22 Jun 2007
Posts: 237
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| Posted: Thu Nov 05, 2009 9:36 am Post subject: |
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I believe Thaler recommended that private investors should invest in index funds because he believes they don't have the knowledge and the ability to exploit inefficiences.
The last article I've read on Thaler's strategies is:
Exploiting Behavior Bias in the Financial Market:
A Study of Fuller & Thaler Asset Management
FINA/MANA 4397, April 2004
| Quote: | ...But after we carefully analyzed the risk and operating expense of F&T mutual funds, we believed that it was very uncertain if Fuller and
Thaler could maintain its above-average performance in a long run.... |
It seems they trade on public information. So they must believe these biases are very stable or they have to invent new quantative models if the old model no longer works.
I also don't know how these funds have performed since then. |
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Wagnerjb
Joined: 19 Feb 2007
Posts: 2975
Location: Houston, Texas
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| Posted: Thu Nov 05, 2009 9:51 am Post subject: |
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| ddb wrote: | | Eugene Fama wrote: | | Toward the end of the book, Fox concludes that passive investing is the right choice for almost all investors. My academic friends in behavioral finance (for example, Richard Thaler) almost always end up with a similar conclusion. |
Dr. Fama is apparently unaware that Richard Thaler is a partner in the firm Fuller & Thaler Asset Management, which has the following written right on its home page:
| Fuller and Thaler wrote: | | Investors make mental mistakes that can cause stocks to be mispriced. Fuller & Thaler’s objective is to use our understanding of human decision making to find these mispriced stocks and earn superior returns. |
In other words, securities are mispriced, and they can identify and exploit the price anomalies.
- DDB |
Unless I am mistaken, the mutual funds that Thaler and his colleagues run have underperformed the market. Lots of people "think" securities are mispriced. We are still waiting for people to demonstrate they can consistently capitalize on this mispricing.
Best wishes.
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superlight
Joined: 31 Mar 2008
Posts: 1033
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| Posted: Thu Nov 05, 2009 10:24 am Post subject: |
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| Wagnerjb wrote: | | Unless I am mistaken, the mutual funds that Thaler and his colleagues run have underperformed the market. Lots of people "think" securities are mispriced. We are still waiting for people to demonstrate they can consistently capitalize on this mispricing. |
I wouldn't blame Thaler for taking an honest shot at it, with OPM. Nothing says he has to succeed, certainly. As long as his [prospectus] describes his plan ;-)
It might not be a coincidence that the sort of dim signals we get about the future, like q, PE/10, CAPE, whatever are hints about longer term trends. A hint about prices a year or two down the line isn't really exploitable by a trader or mutual fund manager. Or if it is, it's for long term holders of his fund, and won't show up in quarter to quarter performace data.
You know, in Fox's Myth a bit of attention is paid to which theories were originally asserted for "one second forward in time" and then applied more generally.
My thinking this week, as I try to balance "no one can time the market" with "valuations matter" is that there are probably some years that are better for getting into the market, and that there are some years where it's better to leave it alone ... but no one really tests rigorous long time scale strategies.
Anybody got a long term Vanguard database? With PE or Q or something? Compare someone who does fixed periodic investing to SP500 and 5yr Treasuries with someone who allocates to those same two, but with a mechanistic decision based on market valuation. I'd think this kind of signal (even if it worked) would be left unexploited by Wall Street because they don't have that decades-long perspective. Even endowment managers are competing on shorter terms than that.
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wearethefall
Joined: 29 Jul 2007
Posts: 155
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| Posted: Thu Nov 05, 2009 10:56 am Post subject: |
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| superlight wrote: | | Wagnerjb wrote: | | Unless I am mistaken, the mutual funds that Thaler and his colleagues run have underperformed the market. Lots of people "think" securities are mispriced. We are still waiting for people to demonstrate they can consistently capitalize on this mispricing. |
I wouldn't blame Thaler for taking an honest shot at it, with OPM. Nothing says he has to succeed, certainly. As long as his [prospectus] describes his plan 
It might not be a coincidence that the sort of dim signals we get about the future, like q, PE/10, CAPE, whatever are hints about longer term trends. A hint about prices a year or two down the line isn't really exploitable by a trader or mutual fund manager. Or if it is, it's for long term holders of his fund, and won't show up in quarter to quarter performace data.
You know, in Fox's Myth a bit of attention is paid to which theories were originally asserted for "one second forward in time" and then applied more generally.
My thinking this week, as I try to balance "no one can time the market" with "valuations matter" is that there are probably some years that are better for getting into the market, and that there are some years where it's better to leave it alone ... but no one really tests rigorous long time scale strategies.
Anybody got a long term Vanguard database? With PE or Q or something? Compare someone who does fixed periodic investing to SP500 and 5yr Treasuries with someone who allocates to those same two, but with a mechanistic decision based on market valuation. I'd think this kind of signal (even if it worked) would be left unexploited by Wall Street because they don't have that decades-long perspective. Even endowment managers are competing on shorter terms than that. |
Andrew Smithers is also thinking along the same lines. He talks about his "imperfectly efficient markets hypothesis" in his new book, Wall Street Revalued. |
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ddb
Joined: 26 Feb 2007
Posts: 3105
Location: Manhattan
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| Posted: Thu Nov 05, 2009 11:04 am Post subject: |
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| Wagnerjb wrote: | | Unless I am mistaken, the mutual funds that Thaler and his colleagues run have underperformed the market. Lots of people "think" securities are mispriced. We are still waiting for people to demonstrate they can consistently capitalize on this mispricing. |
Mixed results. They run two open-end funds that I know of, Undiscovered Managers Behavioral Growth (US small growth) and Behavioral Value (US small value). The latter has excellent peer rankings within its category, while the former has poor peer rankings within its category. The results don't much matter to me either way, I just found it funny that Dr. Fama referred to Dr. Thaler as one who believes in passive investing.
Or, perhaps Dr. Thaler really does believe in passive investing, but is just trying to extract fees from those who place hope above reason. Ethical considerations aside, this may be a brilliant idea, but I note that the two open-end funds have combined assets of only approximately $100 million (over 80% of which is in the lowest-cost institutional share class), so they may not be making much money after all.
- DDB
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Trebor
Joined: 21 Feb 2007
Posts: 211
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| Posted: Thu Nov 05, 2009 11:30 am Post subject: |
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"Defending efficient markets has gotten harder, but it's probably too soon for Mr. Thaler to declare victory. He concedes that most of his retirement assets are held in index funds, the very industry that Mr. Fama's research helped to launch. And despite his research on market inefficiencies, he also concedes that "it is not easy to beat the market, and most people don't.""
From
Mr. Thaler Takes On Mr. Fama
By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL
October 18, 2004; Page A1
Perhaps now he has all his money in his funds?
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superlight
Joined: 31 Mar 2008
Posts: 1033
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| Posted: Thu Nov 05, 2009 11:37 am Post subject: |
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| Trebor wrote: | | Perhaps now he has all his money in his funds? |
He may not recommend that his clients have "all" their money in his funds either.
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Rodc
Joined: 26 Jun 2007
Posts: 4463
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| Posted: Thu Nov 05, 2009 11:43 am Post subject: |
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| superlight wrote: | | Wagnerjb wrote: | | Unless I am mistaken, the mutual funds that Thaler and his colleagues run have underperformed the market. Lots of people "think" securities are mispriced. We are still waiting for people to demonstrate they can consistently capitalize on this mispricing. |
I wouldn't blame Thaler for taking an honest shot at it, with OPM. Nothing says he has to succeed, certainly. As long as his [prospectus] describes his plan
It might not be a coincidence that the sort of dim signals we get about the future, like q, PE/10, CAPE, whatever are hints about longer term trends. A hint about prices a year or two down the line isn't really exploitable by a trader or mutual fund manager. Or if it is, it's for long term holders of his fund, and won't show up in quarter to quarter performace data.
You know, in Fox's Myth a bit of attention is paid to which theories were originally asserted for "one second forward in time" and then applied more generally.
My thinking this week, as I try to balance "no one can time the market" with "valuations matter" is that there are probably some years that are better for getting into the market, and that there are some years where it's better to leave it alone ... but no one really tests rigorous long time scale strategies.
Anybody got a long term Vanguard database? With PE or Q or something? Compare someone who does fixed periodic investing to SP500 and 5yr Treasuries with someone who allocates to those same two, but with a mechanistic decision based on market valuation. I'd think this kind of signal (even if it worked) would be left unexploited by Wall Street because they don't have that decades-long perspective. Even endowment managers are competing on shorter terms than that. |
I did not include periodic investing, but this is part of what you are asking for:
http://home.comcast.net/~rodec....mingV2.pdf
Note that what benefit I found vanished 40 years ago, right about when Tobin's q was developed (ie it works only on the data used to develop it). Alas.
Some will claim this is not a definitive study and they are correct. If I added costs it would have been worse. If I worked harder at data mining no doubt I could have made the results better.
YMMV
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tadamsmar
Joined: 07 May 2007
Posts: 1917
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| Posted: Thu Nov 05, 2009 11:51 am Post subject: |
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| superlight wrote: | It wouldn't surprise me if most professional managers were conflicted, using VaR models based on random walk models based on efficient market models, while at the same time not believing in efficient markets. That would be a problem.
FWIW, Fama's final paragraph makes me angrier than it probably should (I'm a stickler for logical consistency):
| Quote: | | Toward the end of the book, Fox concludes that passive investing is the right choice for almost all investors. My academic friends in behavioral finance (for example, Richard Thaler) almost always end up with a similar conclusion. In my view, this is an admission that the EMH provides a good view of the world for almost all practical purposes. At which point, I say I won. |
No Doctor, if your hypothesis is worth anything, it should be about causality. You should have evidence that markets are "efficient" and that prices really do "reflect all available information." Saying that the behaviorists arrive the same conclusion by a totally different path does not support you.
It is a punt. |
Could you explain how the EMH and the EMMH (the Efficient Market Myth Hypothesis) represent two different paths that both lead to the same conclusion, the conclusion that investors should invest as if the EMH is true?
The EMMH should be ignored if it has nothing better than this to offer. |
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hafis50
Joined: 22 Jun 2007
Posts: 237
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| Posted: Thu Nov 05, 2009 11:57 am Post subject: |
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| Trebor wrote: | "Defending efficient markets has gotten harder, but it's probably too soon for Mr. Thaler to declare victory. He concedes that most of his retirement assets are held in index funds, the very industry that Mr. Fama's research helped to launch. And despite his research on market inefficiencies, he also concedes that "it is not easy to beat the market, and most people don't.""
From
Mr. Thaler Takes On Mr. Fama
By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL
October 18, 2004; Page A1
Perhaps now he has all his money in his funds? |
Thaler - The End of Behavioral Finance, 1999 (FAJ?)
| Quote: | On the other side of the coin is the compelling evidence that markets are efficient: the performance of active fund managers. Many studies have documented the underperformance of mutual fund managers and pension fund managers relative to passive investment strategies (see, for example, Malkiel 1995). Furthermore, although there are always some good performers, good performance this year fails to predict good performance the following year, on average...These cold facts should be kept firmly in mind when evaluating market efficiency. Regardless of the results of academic studies reporting apparently successful trading rules, real-world portfolio managers apparently have no easy time beating the market.
This brief discussion of some of the empirical literature should leave the reader with a mixed impression. Market behavior often diverges from
what we would expect in a rational efficient market, but these anomalies do not create such large profit opportunities that active fund managers as a group earn abnormal returns. No inherent contradiction exists in this combination of facts, although economists have often been confused on this point. A drunk walking through a field can create a random
walk, despite the fact that no one would call his choice of direction rational. Still, if asset prices depended on the path the drunk adopted, it would be a good idea to study how drunks navigate... |
]
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tetractys
Joined: 17 Mar 2007
Posts: 1846
Location: Salish Sea Region
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| Posted: Thu Nov 05, 2009 11:58 am Post subject: |
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| Quote: | | EFF: The premise of the Fox book is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH), which posits that market prices reflect all available information. The claim is that the world's investors and their advisors in the financial industry bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. The most recent is the rise and sharp decline in real estate prices which froze financial markets and led to the worst recession since the Great Depression of the 1930s. |
This EFF assessment of Fox's book is false. While Fox did discredit "blind acceptance of the efficient markets hypothesis," he went on to claim what really happened, institutions shortened the time span in their calculations of risk to suit short term gains. And Fox further stated that EMH, in it's milder forms is the best and only way to proceed into the future, and he used Fama's statements to back that up. I don't think EFF read the book very carefully. -- Tet
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dkturner
Joined: 25 Feb 2007
Posts: 131
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| Posted: Thu Nov 05, 2009 12:11 pm Post subject: |
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| ddb wrote: | | Eugene Fama wrote: | | Toward the end of the book, Fox concludes that passive investing is the right choice for almost all investors. My academic friends in behavioral finance (for example, Richard Thaler) almost always end up with a similar conclusion. |
Dr. Fama is apparently unaware that Richard Thaler is a partner in the firm Fuller & Thaler Asset Management, which has the following written right on its home page:
| Fuller and Thaler wrote: | | Investors make mental mistakes that can cause stocks to be mispriced. Fuller & Thaler’s objective is to use our understanding of human decision making to find these mispriced stocks and earn superior returns. |
- DDB |
Both Fama and Thaler are professors at the University of Chicago. When I read Fama's article on his website I assumed he was speaking from personal knowledge of what Thaler actually does with his money (regardless of what Thaler says others should do with theirs). |
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superlight
Joined: 31 Mar 2008
Posts: 1033
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| Posted: Thu Nov 05, 2009 1:04 pm Post subject: |
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| tadamsmar wrote: | Could you explain how the EMH and the EMMH (the Efficient Market Myth Hypothesis) represent two different paths that both lead to the same conclusion, the conclusion that investors should invest as if the EMH is true?
The EMMH should be ignored if it has nothing better than this to offer. |
I think I said I was a pedantic logician looking at causality. For me, for EMH to be true, the causality has to be true.
In practical terms the difference between "prediction is hard" (EMMH) and "prediction is impossible" (EMH) is indeed small.
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superlight
Joined: 31 Mar 2008
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| Posted: Thu Nov 05, 2009 1:11 pm Post subject: |
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Thanks Rod, I skimmed your interesting paper. It looks like q-believers were penalized in the last long rally because overvaluations continued for so long. Perhaps it's an example of Keynes' market staying irrational longer than we stay solvent.
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Wagnerjb
Joined: 19 Feb 2007
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Location: Houston, Texas
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| Posted: Thu Nov 05, 2009 1:28 pm Post subject: |
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| superlight wrote: | | tadamsmar wrote: | Could you explain how the EMH and the EMMH (the Efficient Market Myth Hypothesis) represent two different paths that both lead to the same conclusion, the conclusion that investors should invest as if the EMH is true?
The EMMH should be ignored if it has nothing better than this to offer. |
I think I said I was a pedantic logician looking at causality. For me, for EMH to be true, the causality has to be true.
In practical terms the difference between "prediction is hard" (EMMH) and "prediction is impossible" (EMH) is indeed small. |
Think of EMH as a theory similar to "UFO's don't exist". There may not be causality to that theory either. You may not be able to prove the theory in a direct manner (you cannot conclusively observe that there are no UFOs), but you can note that no UFO's have ever been proven. Like EMH, this theory explains our world very well, and has never been disproven.
Best wishes.
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superlight
Joined: 31 Mar 2008
Posts: 1033
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| Posted: Thu Nov 05, 2009 1:42 pm Post subject: |
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Not "aliens don't visit because they all exhausted their energy resources(*)"?
I've heard that one, it offers a hypothesis for observed behavior with unprovable causality. Aliens don't visit "because they died in nuclear war" is another.
A good pedantic logician would agree that there is no good evidence of alien visitation(**), but to remain agnostic on Dr. Fama's alien hypotheses.
* - skirts an ancient bogleheads injunction .
** - except it happened to me! just kidding
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tadamsmar
Joined: 07 May 2007
Posts: 1917
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| Posted: Thu Nov 05, 2009 1:46 pm Post subject: |
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| superlight wrote: | | tadamsmar wrote: | Could you explain how the EMH and the EMMH (the Efficient Market Myth Hypothesis) represent two different paths that both lead to the same conclusion, the conclusion that investors should invest as if the EMH is true?
The EMMH should be ignored if it has nothing better than this to offer. |
I think I said I was a pedantic logician looking at causality. For me, for EMH to be true, the causality has to be true.
In practical terms the difference between "prediction is hard" (EMMH) and "prediction is impossible" (EMH) is indeed small. |
The causality is based on traders evaluating stocks with the available information and making offers to sell and buy. These trades determine the price. The traders have a motivation to use the available information optimally. The causal relationship could not be more obvious. |
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hafis50
Joined: 22 Jun 2007
Posts: 237
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| Posted: Thu Nov 05, 2009 1:56 pm Post subject: |
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| superlight wrote: | I think I said I was a pedantic logician looking at causality. For me, for EMH to be true, the causality has to be true.
In practical terms the difference between "prediction is hard" (EMMH) and "prediction is impossible" (EMH) is indeed small. |
1- Even in an efficient market some investors must make profits that cover the costs of analysing securities.
2- The joint-hypothesis problem makes it difficult to prove or refute the EMH.
See this:
| Quote: | ...
"First, any test of efficiency must assume an equilibrium model that defines normal security returns. If efficiency is rejected, this could be because the market is truly inefficient or because an incorrect equilibrium model has been assumed. This joint hypothesis problem means that market efficiency as such can never be rejected.
..."
Campbell, Lo and MacKinlay (1997), page 24 |
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superlight
Joined: 31 Mar 2008
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| Posted: Thu Nov 05, 2009 2:14 pm Post subject: |
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Right hafis50, I might have just rediscovered the "dual hypothesis problem."
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tadamsmar
Joined: 07 May 2007
Posts: 1917
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| Posted: Thu Nov 05, 2009 3:37 pm Post subject: |
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| hafis50 wrote: | | superlight wrote: | I think I said I was a pedantic logician looking at causality. For me, for EMH to be true, the causality has to be true.
In practical terms the difference between "prediction is hard" (EMMH) and "prediction is impossible" (EMH) is indeed small. |
1- Even in an efficient market some investors must make profits that cover the costs of analysing securities.
2- The joint-hypothesis problem makes it difficult to prove or refute the EMH.
See this:
| Quote: | ...
"First, any test of efficiency must assume an equilibrium model that defines normal security returns. If efficiency is rejected, this could be because the market is truly inefficient or because an incorrect equilibrium model has been assumed. This joint hypothesis problem means that market efficiency as such can never be rejected.
..."
Campbell, Lo and MacKinlay (1997), page 24 |
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Nope. You don't need to construct any model, you just need assert that the real market is efficient. |
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Jack
Joined: 27 Feb 2007
Posts: 1077
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| Posted: Thu Nov 05, 2009 3:47 pm Post subject: |
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Where Fama really goes off the rails is in his defense of financial innovation.
| Quote: | | But suppose we buy into the more common negative current view of finance. There is still a big open question. Beginning in the early 1980s, the developed world and some big players in the developing world experienced a period of extraordinary growth. It's reasonable to argue that in facilitating the flow of world savings to productive uses around the world, financial markets and financial institutions played a big role in this growth. Despite any role of finance in the current recession, are the market naysayers really ready to argue that worldwide wealth would be higher today if financial markets and financial institutions didn't develop as they did? |
After two huge asset bubbles and crashes, is there anyone other than Fama at this point who still believes that unrestricted financial innovation has had positive effects? And his claim about recent growth is just factually incorrect as seen here from Krugman.
Contrary to Fama's claim, growth rates peaked in the 1960s when finance was simple and boring and has declined ever since even as finance became more sexy and innovative. When Fama, supposedly a smart guy, makes claims that are so easily debunked, it really hurts his credibility.
Fama's mistake is that he takes a very simple concept like "beating the market is hard" and stretches it to say that "prices are always right, there are no bubbles" and stretches it even farther to say "deregulation is good". |
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ddb
Joined: 26 Feb 2007
Posts: 3105
Location: Manhattan
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| Posted: Thu Nov 05, 2009 3:50 pm Post subject: |
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| Wagnerjb wrote: | | Think of EMH as a theory similar to "UFO's don't exist". There may not be causality to that theory either. You may not be able to prove the theory in a direct manner (you cannot conclusively observe that there are no UFOs), but you can note that no UFO's have ever been proven. Like EMH, this theory explains our world very well, and has never been disproven. |
Love the analogy. Likewise, think of EMH as a theory similar to "There is no God". You may not be able to prove the theory in a direct manner (you cannot conclusively observe that God does exist), but you can note that God's existence has never been proven. Like EMH, this theory explains our world very well, and has never been disproven.
- DDB
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superlight
Joined: 31 Mar 2008
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| Posted: Thu Nov 05, 2009 3:57 pm Post subject: |
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| ddb wrote: | | Love the analogy. Likewise, think of EMH as a theory similar to "There is no God". You may not be able to prove the theory in a direct manner (you cannot conclusively observe that God does exist), but you can note that God's existence has never been proven. Like EMH, this theory explains our world very well, and has never been disproven. |
I think EMH is a claim about a particular god, [an] informational one.
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superlight
Joined: 31 Mar 2008
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| Posted: Thu Nov 05, 2009 4:24 pm Post subject: |
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| tadamsmar wrote: | | The causality is based on traders evaluating stocks with the available information and making offers to sell and buy. These trades determine the price. The traders have a motivation to use the available information optimally. The causal relationship could not be more obvious. |
Have you heard of narrative fallacy? It's the idea that a story of causation is so attractive that it convinces the reader beyond evidence.
Certainly traders trade based on information, and emotion, and second guessing what the other guy will do in the future. Fama distills that down to one particular kind of thinking, in an utterly unprovable way.
Again, Keynes' beauty contest explains it as well, without informational efficiency.
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hafis50
Joined: 22 Jun 2007
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| Posted: Fri Nov 06, 2009 4:54 am Post subject: |
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| superlight wrote: | | tadamsmar wrote: | | The causality is based on traders evaluating stocks with the available information and making offers to sell and buy. These trades determine the price. The traders have a motivation to use the available information optimally. The causal relationship could not be more obvious. |
Have you heard of narrative fallacy? It's the idea that a story of causation is so attractive that it convinces the reader beyond evidence.
Certainly traders trade based on information, and emotion, and second guessing what the other guy will do in the future. Fama distills that down to one particular kind of thinking, in an utterly unprovable way.
Again, Keynes' beauty contest explains it as well, without informational efficiency. |
I believe the joint-hypothesis problem means that we cannot refute the EMH ("This joint hypothesis problem means that market efficiency as such can never be rejected."
Doesn't this also mean that we cannot prove the truth of any theory that competes with the EMH?
Wouldn't this mean you cannot use this problem as an argument against the truth of the EMH?
(And maybe it could mean that you cannot expect to prove 'causality' in any model of social behavior).
Furthermore, isn't Keynes' beauty contest a good description of how informationally efficient markets work?
Keynes states that the outguessing of the decisions and beliefs of the other traders continues to the umpteenth level.
Why is the number of levels unlimited? Because all available information cannot remove all uncertainties. The knowledge will alwasy be incomplete.
Both the knowledge and the competitive advantage and the costs of information increase with every level.
As every investor has her own limited budget to buy information ('levels') all investors will have different levels of information and,.therefore, different probabilities of beating the competitors.
They must estimate the knowledge of the other investors and invest so much that the estimated (uncertain) return covers the costs of information.
The market would be informationally inefficient if a very low level of information (costs of information) would be sufficient to beat the competitors.
The observation that cheap index funds can beat a high number of professional investors does not support the view that the market is very infornationally inefficient. |
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Rodc
Joined: 26 Jun 2007
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| Posted: Fri Nov 06, 2009 8:06 am Post subject: |
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| superlight wrote: | | Thanks Rod, I skimmed your interesting paper. It looks like q-believers were penalized in the last long rally because overvaluations continued for so long. Perhaps it's an example of Keynes' market staying irrational longer than we stay solvent. |
You are welcome. That sounds like good explanation of the problem.
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tadamsmar
Joined: 07 May 2007
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| Posted: Fri Nov 06, 2009 10:21 am Post subject: |
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| superlight wrote: | | tadamsmar wrote: | | The causality is based on traders evaluating stocks with the available information and making offers to sell and buy. These trades determine the price. The traders have a motivation to use the available information optimally. The causal relationship could not be more obvious. |
Have you heard of narrative fallacy? It's the idea that a story of causation is so attractive that it convinces the reader beyond evidence.
Certainly traders trade based on information, and emotion, and second guessing what the other guy will do in the future. Fama distills that down to one particular kind of thinking, in an utterly unprovable way.
Again, Keynes' beauty contest explains it as well, without informational efficiency. |
But, superlight, in order for you to be consistent you must reject Keynes' narrative because Keynes provided no proof. In fact he is factually wrong. Stocks are not beautiful. Accepting this silly metaphor will just cause you to stop thinking about the real considerations that set the price of stock.
Concerning the idea that the EMH is unprovable, well it's not a statement in logic or formal mathematics when applied to real markets (as opposed to models), so you can't prove it. |
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superlight
Joined: 31 Mar 2008
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| Posted: Fri Nov 06, 2009 10:39 am Post subject: |
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You guys are absolutely correct. I cannot favor Keynes, only use him as a foil, as an example.
What this is really about is theory agnosticism. We can observe that markets are difficult-to-impossible to predict, but we must be wary about the causes.
Or fickle about the causes. I think flexibility like that is important because it keeps us in the muddy middle ground between prices are right (Fama) and prices are wrong (Keynes). (To over-simplify.)
Certainly having one eye on Keynes would have kept us open to the possibility of fads, manias, bubbles, and crashes in a way that just-Fama would not.
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superlight
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| Posted: Fri Nov 06, 2009 10:44 am Post subject: |
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BTW, we can throw things like Hyman Minsky's Financial Instability Hypothesis into the mix.
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hafis50
Joined: 22 Jun 2007
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| Posted: Fri Nov 06, 2009 12:14 pm Post subject: |
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| superlight wrote: | | Certainly having one eye on Keynes would have kept us open to the possibility of fads, manias, bubbles, and crashes in a way that just-Fama would not. |
A very strict version of EMH could assert that prices are do not deviate from the fair value but I think this is not Fama's view
I recall he said/wrote that prices can deviate and that markets can overreact and underreact but only in a random manner so that nobody can earn abnormal profits (see his articles/ interviews on dfaus and Thaler's example of the walk of a drunken man in my previous post).
BTW, I googled a little bit and found that it seems that the 'beauty contest' is a concept that is not only related to fads and irrationalities:
Google for 'beauty contest economies' or see page one of üMorris/Shin - Global Games and Applications |
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superlight
Joined: 31 Mar 2008
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| Posted: Fri Nov 06, 2009 3:43 pm Post subject: |
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Markets which "overreact and underreact but only in a random manner" would not mean-revert. I think they do.
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tadamsmar
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| Posted: Fri Nov 06, 2009 4:11 pm Post subject: |
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| superlight wrote: | | Markets which "overreact and underreact but only in a random manner" would not mean-revert. I think they do. |
The US stock market evidences mean reversion in that past.
That is not sufficient evidence to support the statement that "Markets mean revert".
I would agree that markets that are very successful at a given time evidence mean reversion in their trailing returns. Perhaps even all markets that are sufficiently successful to not get shut down by a revolution show some mean reversion in their trailling returns, I am not sure. But these markets represent censored samples of all markets. |
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hafis50
Joined: 22 Jun 2007
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| Posted: Sat Nov 07, 2009 4:12 am Post subject: |
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| superlight wrote: | | Markets which "overreact and underreact but only in a random manner" would not mean-revert. I think they do. |
Fama interviewed by Tanous (DFA website):
Fama:"...I think the crash in '87 was a mistake.
T.: But if '87 was a mistake, doesn't that suggest that there are moments in time when markets are not efficiently priced?
F.: Well, no. Take the previous crash in 1929. That one wasn't big enough. So you have two crashes. One was too big [1987] and one was too small [1929]!
T.: But in an efficient market context, how are these crashes accounted for in terms of "correct pricing"? I mean, if the market was correctly priced on Friday, why did we need a crash on Monday?
F.: That's why I gave the example of two crashes. Half the time, the crashes should be too little, and half the time they should be too big.
T.: That's not doing it for me. What am I missing?
F.: Think of a distribution of errors. Unpredictable economic outcomes generate price changes. The distribution is around a mean—the expected return that people require to hold stocks. Now that distribution, in fact, has fat tails. That means that big pluses and big minuses are much more frequent than they are under a normal distribution. So we observe crashes way too frequently, but as long as they are half the time under-reactions and half the time over-reactions, there is nothing inefficient about it." |
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superlight
Joined: 31 Mar 2008
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| Posted: Sat Nov 07, 2009 6:00 am Post subject: |
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| Quote: | | Think of a distribution of errors. Unpredictable economic outcomes generate price changes. The distribution is around a mean—the expected return that people require to hold stocks. Now that distribution, in fact, has fat tails. That means that big pluses and big minuses are much more frequent than they are under a normal distribution. So we observe crashes way too frequently, but as long as they are half the time under-reactions and half the time over-reactions, there is nothing inefficient about it." |
That strikes me as an odd claim, "as long as they are half the time under-reactions and half the time over-reactions, there is nothing inefficient about it."
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hafis50
Joined: 22 Jun 2007
Posts: 237
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| Posted: Sat Nov 07, 2009 1:37 pm Post subject: |
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| superlight wrote: | | Quote: | | Think of a distribution of errors. Unpredictable economic outcomes generate price changes. The distribution is around a mean—the expected return that people require to hold stocks. Now that distribution, in fact, has fat tails. That means that big pluses and big minuses are much more frequent than they are under a normal distribution. So we observe crashes way too frequently, but as long as they are half the time under-reactions and half the time over-reactions, there is nothing inefficient about it." |
That strikes me as an odd claim, "as long as they are half the time under-reactions and half the time over-reactions, there is nothing inefficient about it." |
I guess it means that the direction (under- or overreaction) and the magnitude of mistakes are random (unbiased).
All mistakes have similar probabilities (ex ante) so that abnormal profits cannot be earned..
BTW, Paul Farrell wrote about Fuller/Thaler funds in September:
Farrell - Lazy portfolios floor behavioral-finance-funds
Over a five-year period all Lazy Portolios outperformed the two Fuller/Thaler funds.
He quotes a | Quote: | | "2006 research study by three finance professors from Florida State and Central Michigan universities. They analyzed "16 mutual funds that are self-proclaimed or media-identified disciples of behavioral finance," including the two Fuller-Thaler funds. Conclusion: "Behavioral mutual funds are essentially value funds [and] exhibit no ability to time risk-return opportunities" because "investing based on the principles of behavioral finance is indistinguishable from value investing." |
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baw703916
Joined: 01 Apr 2007
Posts: 1834
Location: Northern Virginia
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| Posted: Sat Nov 07, 2009 2:34 pm Post subject: |
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The statement that market if perfectly efficient in the sense that nobody can make abnormal profits can't be completely correct.
What makes a market efficient is that people quickly identify and exploit mispricings and inefficiencies. But if nobody could make abnormal profits by doing so, they wouldn't bother--in which case there's nothing to maintain market efficiency.
The market can't be perfectly efficient. This doesn't mean that assuming an efficient market as a "reasonable approximation" for investing and financial planning purposes isn't appropriate, or that the majority of investors should spend an inordinate amount of time trying to find inefficiencies.
I don't quite understand Fama's point about most investing being done by professional active managers. Maybe the managers are professional and free of emotions, but one can see by fund flows that the investors in their funds aren't. As long as individual investors keep buying high and selling low, it creates inefficiency.
Brad
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