Is EMH a tautology?

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Lauretta
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Is EMH a tautology?

Post by Lauretta » Sat Oct 13, 2018 4:39 am

In a discussion yesterday where I was trying to articulate my thoughts on EMH, I wrote that since EMH cannot be tested because it has no predictive power (due to the joint hypothesis problem - meaning that you will never kown whether it's EMH that is false, or the asset pricing model used that is false), it has no scientific value as a hypothesis: as Karl Popper noted, scientific statements must be falsifiable to be meaningful.

viewtopic.php?f=10&t=261191&p=4163099#p4162277

Since the response of several posters was that I did not understand EMH, I researched it a bit further and came across this post, saying the same thing:

https://obliviousinvestor.com/testing-e ... s-problem/

In other words, one will never be able to prove that EMH is wrong, because it is always possible to 'blame' the asset pricing model, and say that it's the latter that needs improving.

The author of the post is regularly invited to speak at Bogleheads meetings, so perhaps his opinion will give more authority to this statement.
To be sure his piece concludes that since EMH cannot be falsified, one should be wearly of those who say they proved it's wrong.

But my claim is that precisely because it cannot be tested and thus is not falisfiable, it has absolutely no scientific value. It is just a tautology and I am more and more puzzled why people (besides academics) take it seriously.

In fact even Fama thinks that the momentum effect makes EMH very dubious, since one would need a particular crazy asset pricing model to justify the quickly shifting risk in momentum stocks. I saw a video in which Fama joked that he hopes that the momentum effect goes away, so that EMH will become more believable (or less incredible). Perhaps this gives an indication of how EMH should be taken, light heartedly and more as a joke, rather than with the seriousness and dogmatic attitude that many (who aren't equipped to think of the grounds on which it is built) have?
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Re: Is EMH a tautology?

Post by lack_ey » Sat Oct 13, 2018 5:05 am

I haven't seen the prior discussion, but the issues with EMH and joint hypothesis problem I thought were well known here, and I've seen mentions of that many times.

A person invoking EMH should also describe the pricing model they are envisioning, where relevant.

That said, for practical purposes for the sake of discussion we can probably assume "reasonable" pricing models. EMH holding only under conditions of totally irrational and unpredictable pricing would be pretty meaningless, not to mention that it would run counter to the spirit and idea of the whole thing.

We only talk about EMH under the understanding that it is a model that is not 100% correct anyway. No models of this type in markets are supposed to describe the world perfectly, just potentially in some or many contexts, usefully enough.

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Re: Is EMH a tautology?

Post by Lauretta » Sat Oct 13, 2018 5:12 am

lack_ey wrote:
Sat Oct 13, 2018 5:05 am


We only talk about EMH under the understanding that it is a model that is not 100% correct anyway. No models of this type in markets are supposed to describe the world perfectly, just potentially in some or many contexts, usefully enough.
Yes, my claim was precisely that it is not a model. A model must be testable. EMH isn't. As such it is a tautology, not a model.
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Re: Is EMH a tautology?

Post by lack_ey » Sat Oct 13, 2018 5:21 am

Lauretta wrote:
Sat Oct 13, 2018 5:12 am
lack_ey wrote:
Sat Oct 13, 2018 5:05 am


We only talk about EMH under the understanding that it is a model that is not 100% correct anyway. No models of this type in markets are supposed to describe the world perfectly, just potentially in some or many contexts, usefully enough.
Yes, my claim was precisely that it is not a model. A model must be testable. EMH isn't. As such it is a tautology, not a model.
Sorry, in the end there I meant "model" in the least precise way.

If you require something to be falsifiable to be a model, then including a precising model in that sentence. No combination of EMH+pricing model is going to be accurate all the time.


It depends on context as to what this means for "predictive power." I think it's rarely appropriate to invoke EMH when making predictions of anything. The concept is useful for intuition for simple ideas in some scenarios. I wouldn't go far past that, especially not to convince somebody else of something contentious. But I would also hesitate to say "no predictive power" because it can be close enough to reality (assuming some reasonable pricing model) for a number of circumstances and uses.


For example, if somebody says, "I heard X about S&P 500 stock Y on the news yesterday and want to buy/sell," I would say that you can reasonably point out that in such a widely traded and followed stock, this information is already included in the pricing (you're not going to get ahead of the market; it's already thought about this and made many many trades since this was known) in the EMH sense. Though it could be that the market pricing for what is included is too low or high. Potentially. That part depends on how information gets reflected in pricing. Many people trying to invoke EMH also I think are implicitly assuming a pricing model where the price incorporated is "correct" in some sense.

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Re: Is EMH a tautology?

Post by AlohaJoe » Sat Oct 13, 2018 5:36 am

Lauretta wrote:
Sat Oct 13, 2018 4:39 am
It is just a tautology and I am more and more puzzled why people (besides academics) take it seriously.
Academics don't take it seriously. They haven't taken it seriously since Sitglitz & Grossman's 1975 paper (i.e. 43 years ago). Shiller's 1981 paper (i.e. 37 years ago) was the nail in the coffin. Eugene Fama is the only academic of note that believes in it.

As Andrew Ang puts it flatly in his book Asset Management, "Today, economists do not believe in perfectly efficient markets."

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Re: Is EMH a tautology?

Post by Lauretta » Sat Oct 13, 2018 6:06 am

AlohaJoe wrote:
Sat Oct 13, 2018 5:36 am
Lauretta wrote:
Sat Oct 13, 2018 4:39 am
It is just a tautology and I am more and more puzzled why people (besides academics) take it seriously.
Academics don't take it seriously. They haven't taken it seriously since Sitglitz & Grossman's 1975 paper (i.e. 43 years ago). Shiller's 1981 paper (i.e. 37 years ago) was the nail in the coffin. Eugene Fama is the only academic of note that believes in it.

As Andrew Ang puts it flatly in his book Asset Management, "Today, economists do not believe in perfectly efficient markets."
Well it's in the Syllabus of many universities I know. In any case my question was why so many other people, in particular on this Board (though you don't seem to be one of them) take it seriosuly.
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Re: Is EMH a tautology?

Post by AlohaJoe » Sat Oct 13, 2018 6:14 am

Lauretta wrote:
Sat Oct 13, 2018 6:06 am
Well it's in the Syllabus of many universities I know. In any case my question was why so many people, in particular on this Board (though you don't seem to be one of them) take it seriosuly.
It is a useful short hand. Just like universities teach Newtonian mechanics. It isn't right but it is close enough, especially for individual investors. If we always said something long winded like "markets aren't efficient but after search costs, transaction costs, and others costs the inefficiencies are so small they need to be leveraged up significantly (e.g. 5x) and are ephemeral (lasting less than 1 second) and [insert 10 more pages of disclaimers]".

In the context of individual investors EMH is a perfectly fine guiding principle; more fortunes have been lost trying to beat the market than in simply accepting what the market gives you.

Keep in mind that the most common pro-EMH reply is something like "what do you know that the market doesn't" and 99.99% of posters can't offer a coherent reply. "I saw an article on CNBC or Zero Hedge" doesn't cut it.

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Re: Is EMH a tautology?

Post by dratkinson » Sat Oct 13, 2018 6:48 am

BH Is EMH a tautology



EMH's scientific value. I don't have the background to dis/prove it. And reading discussions of deep theory (strong, weak, semi-strong) soon make my head hurt. As an average investor, I need simple action steps to execute.


EMH's personal value. It offers an explanation for why my past stock-picking attempts failed---lower return than the market. It persuades me that any future stock-picking attempt will also be unsuccessful.

For those reasons, I believe it has personal value as a "rule of thumb" to encourage the average investor to avoid the behavioral error of believing s/he can ever know more than the market. And once accepted, it allows us to simplify our lives by gracefully accepting the market return.


Simple action step. I believe EMH is a close enough explanation to what is actually happening in the market, that the average investor can assume it is true, and accept the simplification it offers.

The academics can keep working… and let us know when they have a better explanation… that can be turned into simple action steps. :)
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Re: Is EMH a tautology?

Post by nisiprius » Sat Oct 13, 2018 7:00 am

I take it seriously--not the version that says the omniscient market sees all and knows all, centuries into the future, though.

A lot of important, useful, valuable concepts can be called tautologies if you want to. For example, the first law of thermodynamics is a tautology because whenever energy isn't conserved, some new form of "energy" is defined or created to make the equation balance. Natural selection is a tautology; the fittest survive because the only way to determine fitness is by observing survival. Newton's laws of motion as expressed by f = ma is a tautology, because you can consider it to be no more than definition of the concept of force.

EMH certainly does make testable predictions, the two most obvious being "price movements resemble a random walk" and "it's really hard to beat the index, and lots of clever ideas that really sound as if they should work, don't." Similarly, the first law of thermodynamics predicts that "perpetual motion, aka overunity, aka free energy, is impossible" and thus "lots of clever ideas for overunity engines that really sound as if they should work, don't."

Now, you can go to YouTube and see hundreds of videos (search on "overunity," not "perpetual motion") showing overunity engines actually working. (Or, at least, a bunch of wires and magnets, something spinning on a lab bench, and someone with a meter insisting that it is consuming 22 watts and producing 23, or least, 21.98 watts, and as soon as he gets the part for one last change we can calculate that it will be 22.04).

Do I believe the first law of thermodynamics is true? Yes.

Is my mind open to the possibility that it might not actually be 100.000000% true and there might just possibly be a way to build a perpetual motion machine? Yes.

So will you invest in my overunity engine company? No.

Do I believe the EMH is true? Oh, sure, pretty much roughly.

Is my mind open to the possibility that Warren Buffett, or Bill Miller, or Mebane Faber, or James Simon might be able to take money away from other investors through cleverer analysis or better information. Yes.

"If you believe that it is possible, and I tell you that I invest just like Warren or Bill or Meb or Jim, will you give me all your money to manage and pay me a 1.25 AUM fee?" No.

Let's say EMH is a tautology. What, exactly, does that buy you? The empirical evidence that professional fund managers who try to beat the market don't usually succeed is all in the SPIVA reports. You can just say "nobody actually knows if there's a way to beat the market, and most professionals who try don't succeed, so a sensible thing for an individual investor to do is not to try." If someone asks "why," you can either say "I don't know, but that's what the evidence shows," or you can give a name to the phenomenon, say "it's the efficient market," and "explain" it with the EMH.

Let's just call the EMH a useful rule of thumb. It leads to interesting questions... for example, if someone says "I shall invest in emerging markets because these countries have fast-growing economies," you can legitimately ask "but everybody knows this, why do you think it isn't reflected in a premium price that already assumes future growth?" That's a valid question even if you don't think it is automatically, necessarily, and accurately priced in.
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Re: Is EMH a tautology?

Post by 3CT_Paddler » Sat Oct 13, 2018 7:49 am

Investing isn't science, even if people study it scientifically. Once you throw in human behavior, the "science" of investing is built on shaky ground.

The underpinnings are philosophical and logical... Which don't require a testable scientific hypothesis to be valid.

At the end of the day, costs matter, especially over the long term. Diversification is also beneficial in the long term for investors. Index funds do a better job than any other investment of capturing those two ideas. That is all you need to understand to have a strong logical case for index investing.

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Re: Is EMH a tautology?

Post by vineviz » Sat Oct 13, 2018 8:18 am

nisiprius wrote:
Sat Oct 13, 2018 7:00 am
EMH certainly does make testable predictions, the two most obvious being "price movements resemble a random walk" and "it's really hard to beat the index, and lots of clever ideas that really sound as if they should work, don't."
Indeed, I'd argue the contributions to the EMH which won Fama his Nobel Prize center on this aspect: testability. His 1970 paper, which some say is the most cited paper in financial economics, lays out the way that EMH is testable and reviewed the literature for those tests.

Richard Thaler later and colloquially broke EMH down into its two fundamental components, which he called the No Free Lunch component ("prices are unpredictable and that you can't beat the market") and the Price is Right component ("asset prices are equal to fundamental value").

Thaler calls the first component "mostly true" and I suspect that most economists would go at least that far. Using a Sharpe-Markowitz asset pricing model the evidence is pretty strong that it is almost always true, and using a more sophisticated multi-factor risk model (which I think there is, independently, good evidence to prefer) it's pretty much entirely true. This component has the most practical impact for the individual investor, and is entirely uncontroversial among economists.

The second component is indeed more controversial (this is where the "tautology" claims and worries about the joint hypothesis problem tend to come into play), though a significant chunk of this controversy depends on questions of economic ideology.

Over short time horizons, the evidence is pretty clear that returns are not typically very predictable. These short-run tests are fairly powerful statistically, because there are lots of independent short-tun tests. Shiller proposed that over the long-run there is more return predictability (i.e. asset returns are negatively autocorrelated over longer periods of time), but unfortunately it's hard to gain statistical significance in such long-run tests.

As Fama (1991) himself observed, "a ubiquitous problem in time-series tests of market efficiency, with no clear solution, is that irrational bubbles in stock prices are indistinguishable from rational time-varying expected returns." The folks in Shiller's camp tend to see irrational bubbles where people in the EMH camp tend to see rational changes in expected returns, and it is hard for either camp to put a definitive nail in the other camp's coffin.
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Re: Is EMH a tautology?

Post by Lauretta » Sat Oct 13, 2018 8:29 am

AlohaJoe wrote:
Sat Oct 13, 2018 6:14 am


In the context of individual investors EMH is a perfectly fine guiding principle; more fortunes have been lost trying to beat the market than in simply accepting what the market gives you.

Yes I totally agree, and I think that index funding is good for me. But the reason why it's good for me is that I cannot pick stocks, and I am not able to identify superior fund managers in advance. So a low cost index fund is the best solution for me.
But postulating that index funds are the best solution because of the dogmas of EMH seems to me intellectually dishonest.
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Re: Is EMH a tautology?

Post by arcticpineapplecorp. » Sat Oct 13, 2018 8:43 am

That's what makes the "H" in EMH a hypothesis. If it were "proven" (a difficult term to use considering most scientific research will never use the term proven but will only speak in terms of statistical significance, which means that there's always some percentage chance that results you got were due to chance alone) it would be called EMT (as in Efficient Market Theory). But they can't prove it which is why they use the word hypothesis and not theory. That's my layman's understanding of it.
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Re: Is EMH a tautology?

Post by Lauretta » Sat Oct 13, 2018 8:57 am

arcticpineapplecorp. wrote:
Sat Oct 13, 2018 8:43 am
That's what makes the "H" in EMH a hypothesis. If it were "proven" (a difficult term to use considering most scientific research will never use the term proven but will only speak in terms of statistical significance, which means that there's always some percentage chance that results you got were due to chance alone) it would be called EMT (as in Efficient Market Theory). But they can't prove it which is why they use the word hypothesis and not theory. That's my layman's understanding of it.
Well in science you formulate hypotheses and then devise ways to test them. If they pass the tests the hypotheses become a theory.
EMH can never be a theory because it can never be tested (independently of an asset pricing model). So it's either a 'permanent hypothesis', or a tautology, or (according to some people) it's nonsense, but in any case it certainly has no scientific value.
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Re: Is EMH a tautology?

Post by fortyofforty » Sat Oct 13, 2018 9:05 am

Good question and interesting discussion, Lauretta. :beer
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Re: Is EMH a tautology?

Post by vineviz » Sat Oct 13, 2018 9:17 am

Lauretta wrote:
Sat Oct 13, 2018 8:57 am
Well in science you formulate hypotheses and then devise ways to test them. If they pass the tests the hypotheses become a theory.
EMH can never be a theory because it can never be tested (independently of an asset pricing model). So it's either a 'permanent hypothesis', or a tautology, or (according to some people) it's nonsense, but in any case it certainly has no scientific value.
Even the most prominent critics of EMH will universally acknowledge that, whatever criticisms one might level at it, it is one the MOST valuable foundational blocks in financial economics.
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Re: Is EMH a tautology?

Post by goodenyou » Sat Oct 13, 2018 9:20 am

arcticpineapplecorp. wrote:
Sat Oct 13, 2018 8:43 am
That's what makes the "H" in EMH a hypothesis. If it were "proven" (a difficult term to use considering most scientific research will never use the term proven but will only speak in terms of statistical significance, which means that there's always some percentage chance that results you got were due to chance alone) it would be called EMT (as in Efficient Market Theory). But they can't prove it which is why they use the word hypothesis and not theory. That's my layman's understanding of it.
Is it a conjecture?
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Re: Is EMH a tautology?

Post by Cartographer » Sat Oct 13, 2018 9:33 am

I think of the EMH as a set of logical consequences of assuming rational behavior. Example: suppose there was a way to consistently beat the market (without resorting to insider trading). Then any rational investor/fund manager would follow such strategy and beat the market. But then this new strategy would become the market. Hence, it is impossible to beat the market. In this sense, EMH is a theorem, not a tautology.

Of course, humans aren't rational. Also, there is a time delay between discovering new strategies to beating the market until they become the market. So the inputs to the theorem aren't strictly true. To me, it's not a question of if EMH is true or not, but how far the assumptions rational behavior deviate from the real world. In practice, it seems that the assumptions are reasonably accurate, but certainly not exact. As a result, any logical consequence derived from perfect rationality will have some reasonably small error.

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Re: Is EMH a tautology?

Post by HEDGEFUNDIE » Sat Oct 13, 2018 9:35 am

Lauretta wrote:
Sat Oct 13, 2018 8:57 am
arcticpineapplecorp. wrote:
Sat Oct 13, 2018 8:43 am
That's what makes the "H" in EMH a hypothesis. If it were "proven" (a difficult term to use considering most scientific research will never use the term proven but will only speak in terms of statistical significance, which means that there's always some percentage chance that results you got were due to chance alone) it would be called EMT (as in Efficient Market Theory). But they can't prove it which is why they use the word hypothesis and not theory. That's my layman's understanding of it.
Well in science you formulate hypotheses and then devise ways to test them. If they pass the tests the hypotheses become a theory.
EMH can never be a theory because it can never be tested (independently of an asset pricing model). So it's either a 'permanent hypothesis', or a tautology, or (according to some people) it's nonsense, but in any case it certainly has no scientific value.
All observations are theory-laden and perceptually-bound, whether we are talking about physics or finance.

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Re: Is EMH a tautology?

Post by vineviz » Sat Oct 13, 2018 9:41 am

goodenyou wrote:
Sat Oct 13, 2018 9:20 am
arcticpineapplecorp. wrote:
Sat Oct 13, 2018 8:43 am
That's what makes the "H" in EMH a hypothesis. If it were "proven" (a difficult term to use considering most scientific research will never use the term proven but will only speak in terms of statistical significance, which means that there's always some percentage chance that results you got were due to chance alone) it would be called EMT (as in Efficient Market Theory). But they can't prove it which is why they use the word hypothesis and not theory. That's my layman's understanding of it.
Is it a conjecture?
I don't know what the formal definition of "conjecture" is, but I doubt that it fits EMH.

Someone would need to specific precisely what they mean by "efficient-market hypothesis (EMH)" before they could engage in an (arguably) productive semantic debate about whether what they specified is a theory or a hypothesis.

Most economists call EMH a theory, primarily because it results testable predictions about future (or out-of-sample) events.

EMH has been a central part of economics for so long that pinning down a consensus definition can be challenging. Burton Malkiel has pretty decent take in layman's terms IMHO (emphasis mine):
At the outset, it is important to make clear what I mean by the term “efficiency”.

I will use as a definition of efficient financial markets that they do not allow investors to earn above-average returns without accepting above-average risks. A well-known story tells of a finance professor and a student who come across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, “Don’t bother—if it were really a $100 bill, it wouldn’t be there.” The story well illustrates what financial economists usually mean when they say markets are efficient. Markets can be efficient in this sense even if they sometimes make errors in valuation, as was certainly true during the 1999-early 2000 internet bubble. Markets can be efficient even if many market participants are quite irrational. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends. Many of us economists who believe in efficiency do so because we view markets as amazingly successful devices for reflecting new information rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn above-average risk-adjusted returns. In short, we believe that $100 bills are not lying around for the taking, either by the professional or the amateur investor.
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Re: Is EMH a tautology?

Post by watchnerd » Sat Oct 13, 2018 10:25 am

Lauretta wrote:
Sat Oct 13, 2018 4:39 am
as Karl Popper noted, scientific statements must be falsifiable to be meaningful.
Why are you trying to apply scientific standards of proof to mass market economics?

Behavioral finance has shown our minds are optimized for things other than finance and which often lead to "bad" or irrational financial decisions.

"when Newsweek editor Jon Meacham and I interviewed Greenspan last week and asked what he learned from writing his new memoir, The Age of Turbulence (see an excerpt here and an interview), he said that the experience made him appreciate that human nature is far more complex than what he learned about it from Adam Smith and The Fountainhead.

Greenspan seems to argue that since the case for capitalism is so overwhelmingly rational, the opposition to it must surely stem from very deep-seated, immutable characteristics. “And that carries me to the general conclusion that if you’re going to model an economy, you have to do far better in understanding how the unit of the economy functions—i.e., the human being.”

"Greenspan also turned to psychology and anthropology for explanations of economic irrationality. The erratic behavior of investors during and after bubbles—excessively exuberant on the upside, unwarrantedly pessimistic and fearful on the downside—continuously confounds economists. In his memoir, Greenspan mounts a spirited defense against critics who charge that he too cavalierly let bubbles inflate on his watch. His response: Bubbles, while “extraordinary human behavior, which is not what we could consider ideal,” must be innate. They seem to break out everywhere—again and again. “There’s a long history of forgetting bubbles,” he writes. “But once that memory is gone, there appears to be an aspect of human nature to get cumulative exuberance.” When the bubble inevitably breaks, as reality fails to meet expectations, “the result is a dramatic 180 degree switch from exuberance to fear.”

So what should we learn from bubbles, aside from the fact that they can be great for the economy? The phenomenon, he said, “is ever increasingly suggestive that these market economies are run by consumers, mainly by the innate characteristics of human nature.”

And there is much more at:

https://slate.com/business/2007/09/alan ... ional.html
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Re: Is EMH a tautology?

Post by nisiprius » Sat Oct 13, 2018 10:39 am

Lauretta wrote:
Sat Oct 13, 2018 8:57 am
arcticpineapplecorp. wrote:
Sat Oct 13, 2018 8:43 am
That's what makes the "H" in EMH a hypothesis. If it were "proven" (a difficult term to use considering most scientific research will never use the term proven but will only speak in terms of statistical significance, which means that there's always some percentage chance that results you got were due to chance alone) it would be called EMT (as in Efficient Market Theory). But they can't prove it which is why they use the word hypothesis and not theory. That's my layman's understanding of it.
Well in science you formulate hypotheses and then devise ways to test them. If they pass the tests the hypotheses become a theory.
EMH can never be a theory because it can never be tested (independently of an asset pricing model). So it's either a 'permanent hypothesis', or a tautology, or (according to some people) it's nonsense, but in any case it certainly has no scientific value.
Eh, economics isn't "science," it's "a social science." My alma mater's famous economics department is part of the School of Humanities, Arts, and Social Sciences, thus grouping it with anthropology, linguistics, and political "science."

There's a good deal of "science" to which the "scientific method" can't be applied. And the words "theory" and "hypothesis" get used in a somewhat loose way. Is the Big Bang Theory subject to controlled experimentation? How about Chomsky's "Theory" of Universal Grammar? For that matter, is the "scientific method" itself provable, testable, subject to experiments? Can you divide scientists into two groups and ask one group to follow the scientific method and the control group not to, and demonstrate better results from the first? I don't think "the scientific method" is "scientific!" (That is to say: the scientific, meaning used-by-scientists is not scientific, meaning scientifically-proven).

But, sure, John C. Bogle, in Clash of the Cultures, wrote "Investing is not a science." That's verbatim.
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Re: Is EMH a tautology?

Post by JoMoney » Sat Oct 13, 2018 10:50 am

Lauretta wrote:
Sat Oct 13, 2018 4:39 am
...But my claim is that precisely because it cannot be tested and thus is not falisfiable, it has absolutely no scientific value. It is just a tautology and I am more and more puzzled why people (besides academics) take it seriously...
Sounds about right to me, even worse than not being correct, it's 'not even wrong'.

But I don't take issue with the idea that most people are better off treating the broad market as if it's weakly efficient, and they're unlikely to have special information giving them an advantage. I do think if the market isn't efficient, there is an even stronger case for a 'know nothing' investor to use low cost broad market index funds, and avoid trading. The EMH would imply that everyone is on equal footing on a "risk adjusted" basis, without EMH investors may be taken advantage of by people who do have unique information or positions in the market. At the fringes, It's clearly the case that salesmen convince some people to buy financial products where the buyer has a clear disadvantage.
Last edited by JoMoney on Sat Oct 13, 2018 10:52 am, edited 1 time in total.
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Re: Is EMH a tautology?

Post by watchnerd » Sat Oct 13, 2018 10:52 am

nisiprius wrote:
Sat Oct 13, 2018 10:39 am
Lauretta wrote:
Sat Oct 13, 2018 8:57 am
arcticpineapplecorp. wrote:
Sat Oct 13, 2018 8:43 am
That's what makes the "H" in EMH a hypothesis. If it were "proven" (a difficult term to use considering most scientific research will never use the term proven but will only speak in terms of statistical significance, which means that there's always some percentage chance that results you got were due to chance alone) it would be called EMT (as in Efficient Market Theory). But they can't prove it which is why they use the word hypothesis and not theory. That's my layman's understanding of it.
Well in science you formulate hypotheses and then devise ways to test them. If they pass the tests the hypotheses become a theory.
EMH can never be a theory because it can never be tested (independently of an asset pricing model). So it's either a 'permanent hypothesis', or a tautology, or (according to some people) it's nonsense, but in any case it certainly has no scientific value.
Eh, economics isn't "science," it's "a social science." My alma mater's famous economics department is part of the School of Humanities, Arts, and Social Sciences, thus grouping it with anthropology, linguistics, and political "science."

There's a good deal of "science" to which the "scientific method" can't be applied. And the words "theory" and "hypothesis" get used in a somewhat loose way. Is the Big Bang Theory subject to controlled experimentation? How about Chomsky's "Theory" of Universal Grammar? For that matter, is the "scientific method" itself provable, testable, subject to experiments? Can you divide scientists into two groups and ask one group to follow the scientific method and the control group not to, and demonstrate better results from the first?

But, sure, John C. Bogle, in Clash of the Cultures, wrote "Investing is not a science." That's verbatim.
Right.

I put EMH, despite it's technical, modern sounding name, in the same bucket with Smith's "Invisible Hand" or Ricardo's "Comparative Advantage". They're rules of thumb that help you mentally frame questions, not laws of physics.
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Re: Is EMH a tautology?

Post by whodidntante » Sat Oct 13, 2018 10:54 am

Lauretta wrote:
Sat Oct 13, 2018 4:39 am
In fact even Fama thinks that the momentum effect makes EMH very dubious, since one would need a particular crazy asset pricing model to justify the quickly shifting risk in momentum stocks.
This is one reason that we can still trust Fama as a scientist, which sometimes goes away in someone with his status and accomplishments. I view EMH as a model, a way of understanding how markets work. It is not infallible or even true, but it does not have to be to have value.

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Re: Is EMH a tautology?

Post by Phineas J. Whoopee » Sat Oct 13, 2018 1:21 pm

Lauretta wrote:
Sat Oct 13, 2018 4:39 am
In a discussion yesterday where I was trying to articulate my thoughts on EMH, I wrote that since EMH cannot be tested because it has no predictive power (due to the joint hypothesis problem - meaning that you will never kown whether it's EMH that is false, or the asset pricing model used that is false), it has no scientific value as a hypothesis: as Karl Popper noted, scientific statements must be falsifiable to be meaningful.

viewtopic.php?f=10&t=261191&p=4163099#p4162277

Since the response of several posters was that I did not understand EMH, I researched it a bit further and came across this post, saying the same thing:

https://obliviousinvestor.com/testing-e ... s-problem/

In other words, one will never be able to prove that EMH is wrong, because it is always possible to 'blame' the asset pricing model, and say that it's the latter that needs improving.

The author of the post is regularly invited to speak at Bogleheads meetings, so perhaps his opinion will give more authority to this statement.
To be sure his piece concludes that since EMH cannot be falsified, one should be wearly of those who say they proved it's wrong.

But my claim is that precisely because it cannot be tested and thus is not falisfiable, it has absolutely no scientific value. It is just a tautology and I am more and more puzzled why people (besides academics) take it seriously.

In fact even Fama thinks that the momentum effect makes EMH very dubious, since one would need a particular crazy asset pricing model to justify the quickly shifting risk in momentum stocks. I saw a video in which Fama joked that he hopes that the momentum effect goes away, so that EMH will become more believable (or less incredible). Perhaps this gives an indication of how EMH should be taken, light heartedly and more as a joke, rather than with the seriousness and dogmatic attitude that many (who aren't equipped to think of the grounds on which it is built) have?
The Efficient Market Hypothesis, as correctly noted upthread, is only a hypothesis, not a theory.

The EMH is not an argument from authority. It has its own internal logic.

Academics are not stupid.

The EMH does not speak of perfect pricing. That pricing cannot be shown to be perfect is not an argument against it.

I'm afraid, OP, you're referencing a popular parody of the EMH, not the EMH itself. Please read the link.

PJW

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Re: Is EMH a tautology?

Post by watchnerd » Sat Oct 13, 2018 2:28 pm

As somebody with a brother who teaches economics (who tends to have worse investment returns than I do, mainly due to analysis paralysis) and has engineering coworkers, who tend to try to 'solve the algorithm' before committing resources, I think the stock market is particularly vexing for many smart, left-brained people.

I tend to advise them to think like a military general, instead:

1. You have to go to war with the army you have, not the army you wish you had
2. Be careful about mindsets geared towards 'winning the last war'
3. No plan survives contact with the enemy
4. The fog of war is inevitable -- you will never have perfect, or perhaps even decent, information
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Re: Is EMH a tautology?

Post by Lauretta » Sat Oct 13, 2018 4:12 pm

Phineas J. Whoopee wrote:
Sat Oct 13, 2018 1:21 pm


The EMH is not an argument from authority. It has its own internal logic.

Academics are not stupid.

The fact that it has internal consistency does not make it true. The internal consistency may be useful in the academic world; papers can be published and people can get tenure thanks to it; but it doesn't make the hypothesis any more true.

Some academics are indeed smart: Karl Popper, whom I quoted above, was one of them; Robert Shiller, who showed that EMH is nonsense, is another one of them in my opinion.
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Re: Is EMH a tautology?

Post by JoMoney » Sat Oct 13, 2018 4:16 pm

The irony of the Nobel for Prof. Fama and EMH, is Prof. Shiller receiving a Nobel for CAPE at the same time.
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Re: Is EMH a tautology?

Post by vineviz » Sat Oct 13, 2018 4:18 pm

Lauretta wrote:
Sat Oct 13, 2018 4:12 pm
Robert Shiller, who showed that EMH is nonsense, is another one of them in my opinion.
Shiller is smart, but he never showed that EMH is nonsense.

Not in any way that his peers take seriously, anyway.
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Re: Is EMH a tautology?

Post by watchnerd » Sat Oct 13, 2018 4:24 pm

Lauretta wrote:
Sat Oct 13, 2018 4:12 pm
Phineas J. Whoopee wrote:
Sat Oct 13, 2018 1:21 pm


The EMH is not an argument from authority. It has its own internal logic.

Academics are not stupid.

The fact that it has internal consistency does not make it true. The internal consistency may be useful in the academic world; papers can be published and people can get tenure thanks to it; but it doesn't make the hypothesis any more true.

Some academics are indeed smart: Karl Popper, whom I quoted above, was one of them; Robert Shiller, who showed that EMH is nonsense, is another one of them in my opinion.
As someone who seems grounded in the principles of empiricism, I don't understand why you're wasting neurons on this, either:

1. Ignore EMH if you think it's garbage or
2. Do the research to refute it, publish a paper, win a Nobel

Otherwise, this whole thread is an exercise in polemics and sophistry, signifying nothing except intellectual masturbation.
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Re: Is EMH a tautology?

Post by Valuethinker » Sat Oct 13, 2018 5:06 pm

JoMoney wrote:
Sat Oct 13, 2018 4:16 pm
The irony of the Nobel for Prof. Fama and EMH, is Prof. Shiller receiving a Nobel for CAPE at the same time.
The Nobel committee often balances its prizes in just that way.

Btw Shiller did not receive his Nobel for CAPE10

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Re: Is EMH a tautology?

Post by Valuethinker » Sat Oct 13, 2018 5:09 pm

watchnerd wrote:
Sat Oct 13, 2018 4:24 pm
Lauretta wrote:
Sat Oct 13, 2018 4:12 pm
Phineas J. Whoopee wrote:
Sat Oct 13, 2018 1:21 pm


The EMH is not an argument from authority. It has its own internal logic.

Academics are not stupid.

The fact that it has internal consistency does not make it true. The internal consistency may be useful in the academic world; papers can be published and people can get tenure thanks to it; but it doesn't make the hypothesis any more true.

Some academics are indeed smart: Karl Popper, whom I quoted above, was one of them; Robert Shiller, who showed that EMH is nonsense, is another one of them in my opinion.
As someone who seems grounded in the principles of empiricism, I don't understand why you're wasting neurons on this, either:

1. Ignore EMH if you think it's garbage or
2. Do the research to refute it, publish a paper, win a Nobel

Otherwise, this whole thread is an exercise in polemics and sophistry, signifying nothing except intellectual masturbation.
I disagree.

I can see why a nuclear physicist would ask the question.

In any field a lot of the breakthrus come from people outside the field or using tools and knowledge from outside the field.

The discussion has been interesting to me at least.

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Re: Is EMH a tautology?

Post by Elysium » Sat Oct 13, 2018 5:30 pm

watchnerd wrote:
Sat Oct 13, 2018 4:24 pm
Lauretta wrote:
Sat Oct 13, 2018 4:12 pm
Phineas J. Whoopee wrote:
Sat Oct 13, 2018 1:21 pm


The EMH is not an argument from authority. It has its own internal logic.

Academics are not stupid.

The fact that it has internal consistency does not make it true. The internal consistency may be useful in the academic world; papers can be published and people can get tenure thanks to it; but it doesn't make the hypothesis any more true.

Some academics are indeed smart: Karl Popper, whom I quoted above, was one of them; Robert Shiller, who showed that EMH is nonsense, is another one of them in my opinion.
As someone who seems grounded in the principles of empiricism, I don't understand why you're wasting neurons on this, either:

1. Ignore EMH if you think it's garbage or
2. Do the research to refute it, publish a paper, win a Nobel

Otherwise, this whole thread is an exercise in polemics and sophistry, signifying nothing except intellectual masturbation.
That was my impression all along when I started reading this thread. There is a lot of that goes on here anyway, so doesn't matter end of the day.

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Re: Is EMH a tautology?

Post by MJW » Sat Oct 13, 2018 5:33 pm

I don't know, "polemics and sophistry" seems a bit heavy handed of a charge for this discussion.

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Re: Is EMH a tautology?

Post by triceratop » Sat Oct 13, 2018 5:47 pm

There is a good discussion between Thaler and Fama with Andrew Lo on Youtube, here.

Thaler presents what would otherwise be considered counterexamples of EMH but Fama dismisses their importance, claiming these anomalies as a clear error of the asset pricing model. There is discussion of the joint hypothesis. I don't want to get into too much detail at risk of mischaracterizing what they said.
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Re: Is EMH a tautology?

Post by Dottie57 » Sat Oct 13, 2018 5:48 pm

If the U.S. market is efficient, what caused it to go down much of last week?

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Re: Is EMH a tautology?

Post by triceratop » Sat Oct 13, 2018 5:50 pm

Dottie57 wrote:
Sat Oct 13, 2018 5:48 pm
If the U.S. market is efficient, what caused it to go down much of last week?
Do not confuse efficiency with explainability.
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Re: Is EMH a tautology?

Post by JoMoney » Sat Oct 13, 2018 5:53 pm

There is a pretty fair handed description/presentation from Aswath Damodaran over here:
http://people.stern.nyu.edu/adamodar/pd ... ciency.pdf
 There is an internal contradiction in claiming that there is no
possibility of beating the market in an efficient market and then
requiring profit-maximizing investors to constantly seek out ways of
beating the market and thus making it efficient.
 If markets were, in fact, efficient, investors would stop looking for
inefficiencies
, which would lead to markets becoming inefficient
again.
 It makes sense to think about an efficient market as a self-correcting
mechanism
, where inefficiencies appear at regular intervals
Somewhere, although I can't seem to find it, there's a Buffett quote suggesting along the lines of what a great advantage it is to have schools teaching people that in a game of competitive intelligence that their skills don't make a difference.
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Re: Is EMH a tautology?

Post by Dottie57 » Sat Oct 13, 2018 6:09 pm

triceratop wrote:
Sat Oct 13, 2018 5:50 pm
Dottie57 wrote:
Sat Oct 13, 2018 5:48 pm
If the U.S. market is efficient, what caused it to go down much of last week?
Do not confuse efficiency with explainability.
To my mind it is not terribly efficient togo down or up 2%. And I would think they should go together. Otherwise it is a story of sparrows getting spooked and slowly coming back to the feeder.

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Re: Is EMH a tautology?

Post by watchnerd » Sat Oct 13, 2018 6:14 pm

Dottie57 wrote:
Sat Oct 13, 2018 6:09 pm
triceratop wrote:
Sat Oct 13, 2018 5:50 pm
Dottie57 wrote:
Sat Oct 13, 2018 5:48 pm
If the U.S. market is efficient, what caused it to go down much of last week?
Do not confuse efficiency with explainability.
To my mind it is not terribly efficient togo down or up 2%. And I would think they should go together. Otherwise it is a story of sparrows getting spooked and slowly coming back to the feeder.
How is that not efficient?

The sparrows think they see the shadow of a hawk -- simultaneous access to information -- then scatter.

A bit later, some of them think the hawk is gone and come back to the feeder.
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Re: Is EMH a tautology?

Post by Dottie57 » Sat Oct 13, 2018 6:20 pm

watchnerd wrote:
Sat Oct 13, 2018 6:14 pm
Dottie57 wrote:
Sat Oct 13, 2018 6:09 pm
triceratop wrote:
Sat Oct 13, 2018 5:50 pm
Dottie57 wrote:
Sat Oct 13, 2018 5:48 pm
If the U.S. market is efficient, what caused it to go down much of last week?
Do not confuse efficiency with explainability.
To my mind it is not terribly efficient togo down or up 2%. And I would think they should go together. Otherwise it is a story of sparrows getting spooked and slowly coming back to the feeder.
How is that not efficient?

The sparrows think they see the shadow of a hawk -- simultaneous access to information -- then scatter.

A bit later, some of them think the hawk is gone and come back to the feeder.
They get scared, 99% of the time, by something that is not there which is not efficient. The bluejay has the early warning call for the hawk.

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Re: Is EMH a tautology?

Post by watchnerd » Sat Oct 13, 2018 6:31 pm

Dottie57 wrote:
Sat Oct 13, 2018 6:20 pm
watchnerd wrote:
Sat Oct 13, 2018 6:14 pm
Dottie57 wrote:
Sat Oct 13, 2018 6:09 pm
triceratop wrote:
Sat Oct 13, 2018 5:50 pm
Dottie57 wrote:
Sat Oct 13, 2018 5:48 pm
If the U.S. market is efficient, what caused it to go down much of last week?
Do not confuse efficiency with explainability.
To my mind it is not terribly efficient togo down or up 2%. And I would think they should go together. Otherwise it is a story of sparrows getting spooked and slowly coming back to the feeder.
How is that not efficient?

The sparrows think they see the shadow of a hawk -- simultaneous access to information -- then scatter.

A bit later, some of them think the hawk is gone and come back to the feeder.
They get scared, 99% of the time, by something that is not there which is not efficient. The bluejay has the early warning call for the hawk.
I think you're confusing economic efficiency / utility / outcomes with efficiency of information sharing / efficiency of price discovery.

The EMH does not hypothesize that we all have to take the same course of action in response to the information.
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Re: Is EMH a tautology?

Post by alex_686 » Sat Oct 13, 2018 6:36 pm

Valuethinker wrote:
Sat Oct 13, 2018 5:06 pm
JoMoney wrote:
Sat Oct 13, 2018 4:16 pm
The irony of the Nobel for Prof. Fama and EMH, is Prof. Shiller receiving a Nobel for CAPE at the same time.
The Nobel committee often balances its prizes in just that way.

Btw Shiller did not receive his Nobel for CAPE10
And I will ask what is the contradiction between EMH and CAPE? CAPE makes no prediction if the market is correctly valued, it just a model to predict long term returns.

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Re: Is EMH a tautology?

Post by JoMoney » Sat Oct 13, 2018 6:44 pm

alex_686 wrote:
Sat Oct 13, 2018 6:36 pm
Valuethinker wrote:
Sat Oct 13, 2018 5:06 pm
JoMoney wrote:
Sat Oct 13, 2018 4:16 pm
The irony of the Nobel for Prof. Fama and EMH, is Prof. Shiller receiving a Nobel for CAPE at the same time.
The Nobel committee often balances its prizes in just that way.

Btw Shiller did not receive his Nobel for CAPE10
And I will ask what is the contradiction between EMH and CAPE? CAPE makes no prediction if the market is correctly valued, it just a model to predict long term returns.
CAPE was clumsy shorthand, for his “empirical analysis of asset prices”, that implicitly revolves around assets (at least at times) being priced "irrationally".
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Re: Is EMH a tautology?

Post by AlphaLess » Sat Oct 13, 2018 9:17 pm

EMH is an incomplete and imprecise statement.

From Wikipedia:

"The efficient-market hypothesis (EMH) is a theory in financial economics that states that asset prices fully reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information."

Let's decompose this.

First sentence:
- The efficient-market hypothesis (EMH) is a theory in financial economics that states that asset prices fully reflect all available information.

What do the following mean:
- 'prices'. What does prices mean? And if we figured out prices, is there a timeline assigned to those prices? Prices when? This morning, 1 minute ago, in 1 minute?
- 'all available information':
- - what does 'all' mean?
- - what does 'available' mean? Does 'private' information count?
- - what does 'information' mean?

When the idea comes to Musk to tweet about taking his company private while he is enjoying his weed and thinking about 10 other things, is that available information before he types his tweet? After he types his tweet?

There are real-world considerations:
- information takes time to propagate,
- sometimes not 'all' information is available,
- even if information is 'available', prices take time to reach equilibrium,

As for the second statement in that wikipedia quote, there is no definition of the following:
- impossible,
- beat the market,
- consistent,
- 'risk-adjusted'.

Firstly, as information becomes available, prices don't just magically move to equilibrium. Traders and investors move the prices. So someone gets paid to do that.

Second, you don't have to beat the market to make consistent returns. You may make half the market return, at significantly lower risk. And that may be very very good as far as your portfolio is concerned.

Third, 'risk-adjusted' is a relative concept. Different market participants have different borrowing costs. So risk-adjustment can not be easily defined by using the 'risk-free' asset for everyone.
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Re: Is EMH a tautology?

Post by KyleAAA » Sat Oct 13, 2018 9:20 pm

Is it true that it will ALWAYS be possible to blame the pricing model? That sounds like an assertion that needs justification. We may yet refine the EMH and figure out how to test it effectively.

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Re: Is EMH a tautology?

Post by watchnerd » Sat Oct 13, 2018 9:26 pm

JoMoney wrote:
Sat Oct 13, 2018 6:44 pm
alex_686 wrote:
Sat Oct 13, 2018 6:36 pm
Valuethinker wrote:
Sat Oct 13, 2018 5:06 pm
JoMoney wrote:
Sat Oct 13, 2018 4:16 pm
The irony of the Nobel for Prof. Fama and EMH, is Prof. Shiller receiving a Nobel for CAPE at the same time.
The Nobel committee often balances its prizes in just that way.

Btw Shiller did not receive his Nobel for CAPE10
And I will ask what is the contradiction between EMH and CAPE? CAPE makes no prediction if the market is correctly valued, it just a model to predict long term returns.
CAPE was clumsy shorthand, for his “empirical analysis of asset prices”, that implicitly revolves around assets (at least at times) being priced "irrationally".
Is irrational incompatible with efficient?

I think Bitcoin (or going way back, the Dutch tulip craze) is the perfect test for this. The CAPE model has no idea how to evaluate something like Bitchcoin.

Were Bitcoin prices irrational in December 2017? IMHO, yes.

Were they priced efficiently? I can't think of any reason why they weren't...

(Yes, I know EMH makes no specfic claims outside of equities, but it's a thought experiment to illustrate a point)
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Re: Is EMH a tautology?

Post by vineviz » Sat Oct 13, 2018 9:33 pm

AlphaLess wrote:
Sat Oct 13, 2018 9:17 pm
EMH is an incomplete and imprecise statement.

From Wikipedia:

"The efficient-market hypothesis (EMH) is a theory in financial economics that states that asset prices fully reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information."

Let's decompose this.

First sentence:
- The efficient-market hypothesis (EMH) is a theory in financial economics that states that asset prices fully reflect all available information.

What do the following mean:
- 'prices'. What does prices mean? And if we figured out prices, is there a timeline assigned to those prices? Prices when? This morning, 1 minute ago, in 1 minute?
- 'all available information':
- - what does 'all' mean?
- - what does 'available' mean? Does 'private' information count?
- - what does 'information' mean?

When the idea comes to Musk to tweet about taking his company private while he is enjoying his weed and thinking about 10 other things, is that available information before he types his tweet? After he types his tweet?

There are real-world considerations:
- information takes time to propagate,
- sometimes not 'all' information is available,
- even if information is 'available', prices take time to reach equilibrium,

As for the second statement in that wikipedia quote, there is no definition of the following:
- impossible,
- beat the market,
- consistent,
- 'risk-adjusted'.

Firstly, as information becomes available, prices don't just magically move to equilibrium. Traders and investors move the prices. So someone gets paid to do that.

Second, you don't have to beat the market to make consistent returns. You may make half the market return, at significantly lower risk. And that may be very very good as far as your portfolio is concerned.

Third, 'risk-adjusted' is a relative concept. Different market participants have different borrowing costs. So risk-adjustment can not be easily defined by using the 'risk-free' asset for everyone.
If you're going to try to take down the theory, you'd probably better start with the primary research and not the encyclopedia version.

There is over a century's worth of literature on the topic (and the 1970 paper by Fama, for which he won the nobel prize, is THE most cited paper in financial economics): I think if you dig into it you'll find many of your questions answered and misconceptions dispelled.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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JoMoney
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Re: Is EMH a tautology?

Post by JoMoney » Sat Oct 13, 2018 9:37 pm

watchnerd wrote:
Sat Oct 13, 2018 9:26 pm
...
Were they priced efficiently? I can't think of any reason why they weren't...
I can, namely that the market has/had poor liquidity to cash and was controlled primarily by a few exchanges that have several allegations of fraud against them https://mashable.com/article/sec-coinba ... nts-fraud/

I think one of the more problematic aspects of EMH is the implication that pricing is fair on a "risk adjusted" basis (for some quantifiable measurement of risk that can't quite be found)... I think market(s) have bad actors in them, and shouldn't necessarily be blindly trusted at every level or segment to be offering a fair "risk premium".
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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