14 April 2011
ECMH, A Tidy Theory
The efficient capital markets hypothesis is the view that, given minimally liquid and transparent markets, publicly listed securities will trade at prices that fully reflect all available information.
Comes in three varieties: weak; semi-strong; strong. Discuss each. Here is a helpful link for an analytical take.
I. Some consequences:
A) even the weak version indicates that stock price movements are random. This is counter-intuitive. If markets are rational, shouldn't they be predictable, i.e. non-random? Isn't a "random walk" what a drunk does?
B) if you believe either the strong or the semi-strong version, you will conclude that an investor without material non-public information can never beat the market. It is impossible to beat the market unless you are a crook!
C) Thus, the type of advice that legions of well-paid Wall Streeters are paid to give is worthless. Active asset management in general is worthless. Hedge funds are a star system that preys on the gullible, etc.
Those are the consequences. Let's clear up a couple of misconceptions about the theory:
A) That giving credence to ECMH requires the view that all traders are rational. Consider micro and macro cosms, brain cells, etc.
B) That you can give credence to ECMH and still beat the market by taking a contrarian position.
But why should we believe the theory in any of those forms?
I won't make this presentation a historical one. This chapter needs to be analytic. Still, near the end I can introduce a historical fact, that though it has its roots in classical economics, the clear formulation of ECMH had to wait for 1965, and publications by Eugene Fama and Paul Samuelson.
Knowledge is warranted belief -- it is the body of belief that we build up because, while living in this world, we've developed good reasons for believing it. What we know, then, is what works -- and it is, necessarily, what has worked for us, each of us individually, as a first approximation. For my other blog, on the struggles for control in the corporate suites, see www.proxypartisans.blogspot.com.