17 ms·

Markets are efficient if and only if P = NP

107 points by confluence 14y ago

Bakkot 14y ago
Of course this doesn't mean markets aren't within some small constant factor of being perfectly efficient.
- confluence 14y ago
  Generally with NP-complete problems - that small constant factor is still often an order of magnitude away from optimal (path finding/search/salesman/shortest subsequence etc).
  - sold 14y ago
    In general, approximation of NP-complete problems is not that simple. Assuming P /= NP, Subset-sum can be approximated within 1+epsilon for any requested epsilon>0 [a PTAS] MAX-3SAT can be approximated within 8/7 and not better. Vertex cover can be aproximated within 2 and its not known if that's optimal. Set cover can be approximated within O(log n) and not better. Clique and TSP have no sensible approximation. I would argue that potentially a loss of factor 2 is not an order of magnitude away from optimal. I don't know what is the situation for markets.
- Dn_Ab 14y ago
  Computational Complexity is about asymptotics so constant factors are irrelevant. In this case if perfects markets require numbers of operations that grow astronomically with respect to input and P <> NP then the best we could do are hueristics and approximations. Indeed it is possible (I think likely) that in many cases even getting good approximations will be in NP. Also worth noting is that the expensive nature of being perfectly informed is one of the main drivers of the large sizes of firms. We can measure how well markets are doing with respect to the amount of excess, beyond normal profit that producers can capture in the long term. Current polarization of wealth and excess of rent suggest no, we are very far from efficient markets. There is an argument one can give that the abstraction of interacting humans leads to a computer more powerful than a regular turing machine. I don't believe this but everyone who thinks AI is not possible on a turing machine does.
confluence 14y ago
A slightly long and/or dodgy video by the professor who wrote this (I'm setting your expectations): http://www.youtube.com/watch?v=7iOJZZFDKpc http://www.youtube.com/watch?v=7iOJZZFDKpc I found it rather enlightening - but the paper is still highly readable and I encourage HNers to peruse it and perhaps check out the video as well. Previous discussions: http://news.ycombinator.com/item?id=2895474 http://news.ycombinator.com/item?id=2895474 http://news.ycombinator.com/item?id=1144548 http://news.ycombinator.com/item?id=1144548 More from the professor: http://philipmaymin.com/cv.pdf?q=phil/cv.pdf http://philipmaymin.com/cv.pdf?q=phil/cv.pdf
brador 14y ago
Direct link: http://arxiv.org/pdf/1002.2284v2 http://arxiv.org/pdf/1002.2284v2 [PDF]
kenster07 14y ago
Economics is clear when explaining its foundation: Markets are only as efficient as its participants are rational and fully informed. The entirety of modern economics is built upon the presumption that the last two conditions are 100% true.
- Dn_Ab 14y ago
  True, there is a lot to be learned from behavioural economics. But neoclassiscal stuff is not all bad. The notion of bounded rationality which places limits on the rationality of people is kind of old. And in aggregrate; people, corporations in particular do tend to approximate rationality. This is why they can be 'psychopathic'.
- aristidb 14y ago
  No, it's based on them being true enough that other approximations are less useful models.
  - wisty 14y ago
    Unfortunately, most economists don't develop other models, so the other models are very immature.
  - batista 14y ago
    >No, it's based on them being true enough that other approximations are less useful models. That is, in wishful thinking. No other field has a worse prediction track record that economics.
- Jabbles 14y ago
  Bollocks. Abstract economic theories may be based on these assumptions but the majority of economists make a living on the fact that the market is not efficient.
  - batista 14y ago
    >but the majority of economists make a living on the fact that the market is not efficient. Actually they make a killing on the fact that their are interests and money to be made based on their BS advice and predictions.
pron 14y ago
I have only had time to skim through this very quickly, but it seems entirely based on false definitions. He begins so: The efficient market hypothesis claims that all information relevant to future prices is immediately reflected in the current prices of assets. In other words, you cannot consistently make money using publicly available information. Then, he encodes a 3-SAT problem into market orders and claims: So what should the market do? If it is truly efficient, and there exists some way to execute all of those separate OCO orders in such a way that an overall profit is guaranteed ... then the market, by its assumed efficiency, ought to be able to find a way to do so. So he defines market efficiency to be all-knowing, and then gives at an NP-hard problem to solve. It seems like he could have given it the halting problem as well, only it might be harder to encode as market orders. But the point is that an efficient market is "all knowing" only that which is "knowable". The market isn't an oracle that can answer any question about the past, but a true machine that can answer all questions about the past that are answerable using the machine. What he's doing seems similar to saying "if God exists then P=NP". After all, if God is omniscient and omnipotent, He could solve all NP problems in polynomial time. :)
- ubernostrum 14y ago
  I think this demonstrates, in a clever way, the types of absurdities that result from assumptions economists make about markets and the people who act in them :)
- uvdiv 14y ago
  I skimmed it quickly too, but I think you've misread. The "interesting" claim isn't the 3-SAT encoding; it's earlier where he claims that markets "naturally" have to solve NP-hard problems, in particular that to optimize an investment strategy you have to solve the Knapsack problem. (?!) It's hand-waving nonsense.
  - pron 14y ago
    It doesn't matter. When people say efficient market, they mean that the market knows whatever is knowable by the present time using current technologies. They don't mean that the market knows everything that's theoretically knowable using unknown/impossible algorithms. Before there were computers in an efficient market (supposing one exists), the current prices would reflect everything that is known and can be computed/deduced without computers by the present time. Anyway, the paper misunderstands "known" to mean "anything which can theoretically be known", which obviously includes solutions NP-hard problems. It's just that nobody claims that's what efficient markets are.
stevenrace 14y ago
Previous discussions [Aug. 2011]: - http://news.ycombinator.com/item?id=2895474 http://news.ycombinator.com/item?id=2895474 - http://news.ycombinator.com/item?id=2868498 http://news.ycombinator.com/item?id=2868498
anonymouz 14y ago
Is this a serious paper? I can't judge at all if it is, because I cannot find any useful definitions, exact statement of the claimed theorem or proofs. Then again, I'm not an economist (coming from a mathematics backround), so maybe this is the expected form of a paper here?
- yummyfajitas 14y ago
  The original papers proving similar results do prove theorems. This is one example which springs to mind: http://dpennock.com/papers/chen-ec-2007-betting-on-permutations.pdf http://dpennock.com/papers/chen-ec-2007-betting-on-permutati... Here is a review of the literature from a while back, it cites plenty of actual math papers: http://dpennock.com/papers/pennock-ijcai-workshop-2001-np-markets.pdf http://dpennock.com/papers/pennock-ijcai-workshop-2001-np-ma...
realize 14y ago
The ability of some traders to make consistent significant profits should be an "existence proof" of the inefficiency of markets. The EMH is just wrong.
- evolve2k 14y ago
  The question is not 'can traders make a consistent profit' but rather 'can anyone make a profit using just publicly accessible historical data alone' this is the essence of EMH. Most professional money managers make their gains by actively interviewing companies in a form a stylized intentional financial journalism if you will.
- tatsuke95 14y ago
  Now you just need to point to some traders who are able to make "consistent significant profits".
  - rafcavallaro 14y ago
    And not just "some" but a proportion of profitable traders greater than what we would expect due to chance - i.e. the existence of some lottery winners does not prove that playing the lottery is in general profitable.
meric 14y ago
A while ago I studied a paper where the author proposes using high frequency trading to exploit price patterns. If that can be done profitably it would mean markets aren't even weak form efficient! Lately however there have been emerging views that "efficiency" is not black or white but a continuum. i.e The market will only be efficient enough such that the marginal cost of making the market more efficient is equal to the marginal benefit of doing so. Anyway, I wonder if solutions to NP-complete problems can be approximated using a market. EDIT: According to the paper, they can.
- Dn_Ab 14y ago
  Great point. I am certain that NP-complete problems that can be efficiently approximated can be approximated by markets. No reason why you can't replace algorithms and expertes in your ensemble or regret minimization framework with humans.
- justincormack 14y ago
  "The market will only be efficient enough such that the marginal cost of making the market more efficient is equal to the marginal benefit of doing so." Do we have a model of what markets are like under this type of model? It is not clear to me that prices are even close to what efficient ones might be under this situation (though they could be). Also of course most of the missing markets are the contingent and future ones, which suggests the ways in which things might be biased (forward planning, the firm, the business cycle etc) which are quite important inefficiencies.
  - meric 14y ago
    "Do we have a model of what markets are like under this type of model? It is not clear to me that prices are even close to what efficient ones might be under this situation (though they could be)." I don't know what markets are like under this type of model but here are a two papers recommended by my lecturer on how efficiency is not an either-or proposition. Adaptive Markets and the New World Order "Under the AMH, markets are not always efficient, but they are highly competitive and adaptive, and can vary in their degree of efficiency as the economic environment and investor population change over time." http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1977721&#38 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1977721&#...; Efficient Markets II (by Fama who was the one who originally came up with the efficient market hypothesis describing the three forms of market efficiency) "A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed the marginal costs (Jensen (1978))." http://efinance.org.cn/cn/fm/Efficient%20markets%20II.pdf http://efinance.org.cn/cn/fm/Efficient%20markets%20II.pdf "Also of course most of the missing markets are the contingent and future ones, which suggests the ways in which things might be biased (forward planning, the firm, the business cycle etc) which are quite important inefficiencies." You can often find sets of stock options' prices that you can arbitrage and make a profit, but only if there were no transaction costs. Information will only be taken into account of if the cost of the information (after taking into account all costs including opportunity costs and risk) is less than the benefit from exploiting that information. So, there are probably lots of information from the future that are missing in the market, which if properly exploited will provide a lot of benefit; but the costs of gathering that information is even greater, possibly requiring the use of a time machine. My thinking: It could very well be that markets are only efficient only as far as everything else allows it to be; If investors are not able to evaluate information over more than one business cycle, (due to the cost of doing so, economical or psychological or otherwise), then so be it. The market will move its efficiency to match the environment and its participants.
confluence 14y ago
Honestly - stuff like this reinforces a feeling I have had recently that the social sciences are nothing more than pseudoscience dressed up most of the time. Economists have essentially no idea what is going on and neither do their financial compatriots and the EMH is by far the clearest example of this. I'm trying to make it a personal rule that anything outside of the hard sciences (math/physics/chemistry/statistics etc) is bullshit to me until further notice. I mean really - I do advanced math and statistics in moderately complex systems - AI/robotics - and I can barely wrap my head around them. I shake my head in disgust at those who apply platonic and unrealistic theories to the extremely complex system that is the world. Indeed, the surety they display in their theories amuses me, because to even think that one can reason about the entire world all at once is, in fact, hilarious.
- throwaway64 14y ago
  This kind of armchair criticism is not particularly enlightening, or productive. You can still make useful and largely correct predictions without understanding all of the dynamics in a system. After all, all science amounts to an approximate model, even your vaunted "hard sciences".
  - confluence 14y ago
    I'm sorry but were you alive during the last couple hundred financial crises? I mean if your entire field is dedicated to predicting the future of finance and economics and you don't predict them - it kind of shows that you really don't know what you are doing. All I'm doing is pointing out that the social sciences have no clothes on.
    - jbrechtel 14y ago
      right....because the field of math has never changed course (see: Godel), nor physics (see: Newton, Einstein, )... You're reading too much into the disproportionate effect mistakes in economics have had on society. Science get things wrong all the time...failure is part of the learning process.
Symmetry 14y ago
Does this actually contradict the weak form of the EMH, that "future prices cannot be predicted by analyzing prices from the past"? If it's computationally unfeasible for the market to incorporate new information, surely its then equally computationally unfeasible for some outside observer to predict future prices? I'm not sure this even contradicts the semi-strong form of the EMH, though it clearly does rule out strong EMH.
- confluence 14y ago
  Weak form EMH is so pointless so as to be essentially useless in predictive value. It's like those horoscopes that state - "you will meet someone of great personal importance soon!"
michaelochurch 14y ago
Efficient Market Hypothesis isn't very well defined. It's more like a class of assertions, some of which are demonstrably true and some of which are false. Loosely speaking, it says the market price of an asset (or exchange rate between two assets) will be fair, which means that it corresponds to the expected value of its basic value. If you're talking about a bond, you can look at the (known) payment stream, discount the cash flow, and compute a fair value based on known market conditions. For an equity, there is no fair value other than "the expected value of its price in the future". Some stocks pay dividends, but many don't, so their values are based on something other than a current dividend stream, and largely that "something" is: what is the expected value of the thing in the future? The question is: what is the timeframe? In the very short term, EMH is false for computational reasons. Efficient markets require someone (i.e. an arbitrageur) to keep them efficient. The profits of arbitrage are the incentive for people to keep markets as efficient as possible, and they tend to have this effect. This is an extremely competitive business, and in this day in age, it often comes down to microseconds, but it can be done and billions of dollars are made every day by people who are doing it (and, contrary to popular depictions, arbitrage is actually good for the markets and economy). In the very-long term, EHM is probably also false. By very-long, I'm talking about 10+ years. The reason for this is rooted in the scarcity of money: there are a lot of projects and companies that will produce and capture economic value in the future, but people don't have enough money to fund them all. Hence, stocks are "cheaper" than they should be, and risky growth stocks (much less illiquid private equity) especially so. ("Equity premium.") There are some people who (demonstrably) "get" value investing and are better at predicting long-term corporate futures than others. The issue here is the long feedback cycle. If your frequency of investments is that low, you have no way of knowing if you're actually good, or just getting lucky, especially in the context of the non-normal (i.e. fat-tailed) distribution of equity returns driven by "black swan" events. EMH is true enough that if you don't have the technical machinery to trade at microsecond latency, nor the reputation that will allow you to invest for the very long term despite market caprice-- i.e. even if the market tanks, people will trust Warren Buffett's judgment-- you probably can't reliably make a better profit on the stock market than you'd get if you invested in an index fund. What does EMH rely upon? Ultimately, it says that if there is expectancy to be made selling or buying a security at a price other than P, it will be sold or bought until the price reaches P. This assumes an infinite amount of capital ("smart money") that people are willing to deploy in order to exploit pricing inefficiencies or inconsistencies. This is an obviously false assumption, but for liquid securities of known expected value, it's close enough. Leverage (borrowing) generates a lot of "additional" smart money, so that even a 20bp (0.2%) discrepancy can be levered up into a 10% gain. (If you have $100, borrow $4900, and turn that $5,000 into $5,010, your equity position has gone from $100 to $110.) Microprofit opportunities will be exploited so long as there's sufficient leverage to make them worthwhile, but the willingness of lenders is not infinite. EMH is usually used to make mathematical analyses work. It's a guideline, but no one who understands financial markets believes it to be literally and universally true. No one can actually predict the future or human behavior, but the (false) assumption that there is no arbitrage produces closed-form numbers that are often very close to the real values. Also necessary is the distinction between smart and dumb money. The latter isn't a pejorative; "dumb money" means that there are incentives other than informed speculation. For example, when you buy a house because you want to live somewhere, that's dumb money. Or when an index fund buys stocks because of its chartered requirement to do so, that's "dumb money", not because the buyer is an idiot, but because his purchase doesn't convey information about the stock's real value in the way that smart money would. Markets are efficient when there's enough smart money to keep the dumb flow from pushing the price around. This is going to be true of highly liquid stocks, currency rates, and commodities, but not true of assets like real estate. Financial engineers tend to discount "dumb" activity as harmless Brownian motion, but the 2008 subprime mortgage meltdown established that not to be always wise.
drfloob 14y ago
... and if P = NP, the market doesn't matter because everyone will have cracked all your bank passwords.
csense 14y ago
From the paper: > Now, one may argue that a weaker form of market efficiency as per Fama (1991) and Jensen (1978) is that patterns are exploited until the marginal revenue of further discovery equals the marginal cost of further search. A counterargument to that would be graduate students and other hobbyists and day traders searching for an edge: to them, the marginal cost is zero and at times negative because the value of the search itself, regardless of the outcome, is a positive learning experience for them... A hobbyist has to spend more computation time for every additional strategy they search, which costs real money. The hobbyist's cost is near-zero for small searches -- those that can be done by one person using the computers they already own. Once the size of the search increases beyond what they can manage with their immediately available resources, they have to hire assistants and/or buy computation time like anybody else.
josephlord 14y ago
This is I think a bogus debunking of a bogus theory. Try 'Debunking Economics' by Steve Keen for a good breakdown of real problems with many economic theories including EMH. Mostly by showing the logical fallacies in assumptions but also the naive maths and divergence from empirical reality. http://www.amazon.com/Debunking-Economics-Expanded-Dethroned-ebook/dp/B006BG8UFY/ref=sr_1_1?s=digital-text&ie=UTF8&qid=1348943992&sr=1-1&keywords=steve+keen http://www.amazon.com/Debunking-Economics-Expanded-Dethroned... His blog is http://www.debtdeflation.com/blogs/ http://www.debtdeflation.com/blogs/

107 points by confluence 14y ago

Bakkot 14y ago

Of course this doesn't mean markets aren't within some small constant factor of being perfectly efficient.

confluence 14y ago
Generally with NP-complete problems - that small constant factor is still often an order of magnitude away from optimal (path finding/search/salesman/shortest subsequence etc).
- sold 14y ago
  In general, approximation of NP-complete problems is not that simple. Assuming P /= NP, Subset-sum can be approximated within 1+epsilon for any requested epsilon>0 [a PTAS] MAX-3SAT can be approximated within 8/7 and not better. Vertex cover can be aproximated within 2 and its not known if that's optimal. Set cover can be approximated within O(log n) and not better. Clique and TSP have no sensible approximation. I would argue that potentially a loss of factor 2 is not an order of magnitude away from optimal. I don't know what is the situation for markets.
Dn_Ab 14y ago
Computational Complexity is about asymptotics so constant factors are irrelevant. In this case if perfects markets require numbers of operations that grow astronomically with respect to input and P <> NP then the best we could do are hueristics and approximations. Indeed it is possible (I think likely) that in many cases even getting good approximations will be in NP. Also worth noting is that the expensive nature of being perfectly informed is one of the main drivers of the large sizes of firms. We can measure how well markets are doing with respect to the amount of excess, beyond normal profit that producers can capture in the long term. Current polarization of wealth and excess of rent suggest no, we are very far from efficient markets. There is an argument one can give that the abstraction of interacting humans leads to a computer more powerful than a regular turing machine. I don't believe this but everyone who thinks AI is not possible on a turing machine does.

confluence 14y ago

A slightly long and/or dodgy video by the professor who wrote this (I'm setting your expectations): http://www.youtube.com/watch?v=7iOJZZFDKpc http://www.youtube.com/watch?v=7iOJZZFDKpc I found it rather enlightening - but the paper is still highly readable and I encourage HNers to peruse it and perhaps check out the video as well. Previous discussions: http://news.ycombinator.com/item?id=2895474 http://news.ycombinator.com/item?id=2895474 http://news.ycombinator.com/item?id=1144548 http://news.ycombinator.com/item?id=1144548 More from the professor: http://philipmaymin.com/cv.pdf?q=phil/cv.pdf http://philipmaymin.com/cv.pdf?q=phil/cv.pdf

brador 14y ago

Direct link: http://arxiv.org/pdf/1002.2284v2 http://arxiv.org/pdf/1002.2284v2 [PDF]

kenster07 14y ago

Economics is clear when explaining its foundation: Markets are only as efficient as its participants are rational and fully informed. The entirety of modern economics is built upon the presumption that the last two conditions are 100% true.

Dn_Ab 14y ago
True, there is a lot to be learned from behavioural economics. But neoclassiscal stuff is not all bad. The notion of bounded rationality which places limits on the rationality of people is kind of old. And in aggregrate; people, corporations in particular do tend to approximate rationality. This is why they can be 'psychopathic'.
aristidb 14y ago
No, it's based on them being true enough that other approximations are less useful models.
- wisty 14y ago
  Unfortunately, most economists don't develop other models, so the other models are very immature.
- batista 14y ago
  >No, it's based on them being true enough that other approximations are less useful models. That is, in wishful thinking. No other field has a worse prediction track record that economics.
Jabbles 14y ago
Bollocks. Abstract economic theories may be based on these assumptions but the majority of economists make a living on the fact that the market is not efficient.
- batista 14y ago
  >but the majority of economists make a living on the fact that the market is not efficient. Actually they make a killing on the fact that their are interests and money to be made based on their BS advice and predictions.

pron 14y ago

I have only had time to skim through this very quickly, but it seems entirely based on false definitions. He begins so: The efficient market hypothesis claims that all information relevant to future prices is immediately reflected in the current prices of assets. In other words, you cannot consistently make money using publicly available information. Then, he encodes a 3-SAT problem into market orders and claims: So what should the market do? If it is truly efficient, and there exists some way to execute all of those separate OCO orders in such a way that an overall profit is guaranteed ... then the market, by its assumed efficiency, ought to be able to find a way to do so. So he defines market efficiency to be all-knowing, and then gives at an NP-hard problem to solve. It seems like he could have given it the halting problem as well, only it might be harder to encode as market orders. But the point is that an efficient market is "all knowing" only that which is "knowable". The market isn't an oracle that can answer any question about the past, but a true machine that can answer all questions about the past that are answerable using the machine. What he's doing seems similar to saying "if God exists then P=NP". After all, if God is omniscient and omnipotent, He could solve all NP problems in polynomial time. :)

ubernostrum 14y ago
I think this demonstrates, in a clever way, the types of absurdities that result from assumptions economists make about markets and the people who act in them :)
uvdiv 14y ago
I skimmed it quickly too, but I think you've misread. The "interesting" claim isn't the 3-SAT encoding; it's earlier where he claims that markets "naturally" have to solve NP-hard problems, in particular that to optimize an investment strategy you have to solve the Knapsack problem. (?!) It's hand-waving nonsense.
- pron 14y ago
  It doesn't matter. When people say efficient market, they mean that the market knows whatever is knowable by the present time using current technologies. They don't mean that the market knows everything that's theoretically knowable using unknown/impossible algorithms. Before there were computers in an efficient market (supposing one exists), the current prices would reflect everything that is known and can be computed/deduced without computers by the present time. Anyway, the paper misunderstands "known" to mean "anything which can theoretically be known", which obviously includes solutions NP-hard problems. It's just that nobody claims that's what efficient markets are.

stevenrace 14y ago

Previous discussions [Aug. 2011]: - http://news.ycombinator.com/item?id=2895474 http://news.ycombinator.com/item?id=2895474 - http://news.ycombinator.com/item?id=2868498 http://news.ycombinator.com/item?id=2868498

anonymouz 14y ago

Is this a serious paper? I can't judge at all if it is, because I cannot find any useful definitions, exact statement of the claimed theorem or proofs. Then again, I'm not an economist (coming from a mathematics backround), so maybe this is the expected form of a paper here?

yummyfajitas 14y ago
The original papers proving similar results do prove theorems. This is one example which springs to mind: http://dpennock.com/papers/chen-ec-2007-betting-on-permutations.pdf http://dpennock.com/papers/chen-ec-2007-betting-on-permutati... Here is a review of the literature from a while back, it cites plenty of actual math papers: http://dpennock.com/papers/pennock-ijcai-workshop-2001-np-markets.pdf http://dpennock.com/papers/pennock-ijcai-workshop-2001-np-ma...

realize 14y ago

The ability of some traders to make consistent significant profits should be an "existence proof" of the inefficiency of markets. The EMH is just wrong.

evolve2k 14y ago
The question is not 'can traders make a consistent profit' but rather 'can anyone make a profit using just publicly accessible historical data alone' this is the essence of EMH. Most professional money managers make their gains by actively interviewing companies in a form a stylized intentional financial journalism if you will.
tatsuke95 14y ago
Now you just need to point to some traders who are able to make "consistent significant profits".
- rafcavallaro 14y ago
  And not just "some" but a proportion of profitable traders greater than what we would expect due to chance - i.e. the existence of some lottery winners does not prove that playing the lottery is in general profitable.

meric 14y ago

A while ago I studied a paper where the author proposes using high frequency trading to exploit price patterns. If that can be done profitably it would mean markets aren't even weak form efficient! Lately however there have been emerging views that "efficiency" is not black or white but a continuum. i.e The market will only be efficient enough such that the marginal cost of making the market more efficient is equal to the marginal benefit of doing so. Anyway, I wonder if solutions to NP-complete problems can be approximated using a market. EDIT: According to the paper, they can.

Dn_Ab 14y ago
Great point. I am certain that NP-complete problems that can be efficiently approximated can be approximated by markets. No reason why you can't replace algorithms and expertes in your ensemble or regret minimization framework with humans.
justincormack 14y ago
"The market will only be efficient enough such that the marginal cost of making the market more efficient is equal to the marginal benefit of doing so." Do we have a model of what markets are like under this type of model? It is not clear to me that prices are even close to what efficient ones might be under this situation (though they could be). Also of course most of the missing markets are the contingent and future ones, which suggests the ways in which things might be biased (forward planning, the firm, the business cycle etc) which are quite important inefficiencies.
- meric 14y ago
  "Do we have a model of what markets are like under this type of model? It is not clear to me that prices are even close to what efficient ones might be under this situation (though they could be)." I don't know what markets are like under this type of model but here are a two papers recommended by my lecturer on how efficiency is not an either-or proposition. Adaptive Markets and the New World Order "Under the AMH, markets are not always efficient, but they are highly competitive and adaptive, and can vary in their degree of efficiency as the economic environment and investor population change over time." http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1977721&#38 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1977721&#...; Efficient Markets II (by Fama who was the one who originally came up with the efficient market hypothesis describing the three forms of market efficiency) "A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed the marginal costs (Jensen (1978))." http://efinance.org.cn/cn/fm/Efficient%20markets%20II.pdf http://efinance.org.cn/cn/fm/Efficient%20markets%20II.pdf "Also of course most of the missing markets are the contingent and future ones, which suggests the ways in which things might be biased (forward planning, the firm, the business cycle etc) which are quite important inefficiencies." You can often find sets of stock options' prices that you can arbitrage and make a profit, but only if there were no transaction costs. Information will only be taken into account of if the cost of the information (after taking into account all costs including opportunity costs and risk) is less than the benefit from exploiting that information. So, there are probably lots of information from the future that are missing in the market, which if properly exploited will provide a lot of benefit; but the costs of gathering that information is even greater, possibly requiring the use of a time machine. My thinking: It could very well be that markets are only efficient only as far as everything else allows it to be; If investors are not able to evaluate information over more than one business cycle, (due to the cost of doing so, economical or psychological or otherwise), then so be it. The market will move its efficiency to match the environment and its participants.

confluence 14y ago

Honestly - stuff like this reinforces a feeling I have had recently that the social sciences are nothing more than pseudoscience dressed up most of the time. Economists have essentially no idea what is going on and neither do their financial compatriots and the EMH is by far the clearest example of this. I'm trying to make it a personal rule that anything outside of the hard sciences (math/physics/chemistry/statistics etc) is bullshit to me until further notice. I mean really - I do advanced math and statistics in moderately complex systems - AI/robotics - and I can barely wrap my head around them. I shake my head in disgust at those who apply platonic and unrealistic theories to the extremely complex system that is the world. Indeed, the surety they display in their theories amuses me, because to even think that one can reason about the entire world all at once is, in fact, hilarious.

throwaway64 14y ago
This kind of armchair criticism is not particularly enlightening, or productive. You can still make useful and largely correct predictions without understanding all of the dynamics in a system. After all, all science amounts to an approximate model, even your vaunted "hard sciences".
- confluence 14y ago
  I'm sorry but were you alive during the last couple hundred financial crises? I mean if your entire field is dedicated to predicting the future of finance and economics and you don't predict them - it kind of shows that you really don't know what you are doing. All I'm doing is pointing out that the social sciences have no clothes on.
  - jbrechtel 14y ago
    right....because the field of math has never changed course (see: Godel), nor physics (see: Newton, Einstein, )... You're reading too much into the disproportionate effect mistakes in economics have had on society. Science get things wrong all the time...failure is part of the learning process.

Symmetry 14y ago

Does this actually contradict the weak form of the EMH, that "future prices cannot be predicted by analyzing prices from the past"? If it's computationally unfeasible for the market to incorporate new information, surely its then equally computationally unfeasible for some outside observer to predict future prices? I'm not sure this even contradicts the semi-strong form of the EMH, though it clearly does rule out strong EMH.

confluence 14y ago
Weak form EMH is so pointless so as to be essentially useless in predictive value. It's like those horoscopes that state - "you will meet someone of great personal importance soon!"

michaelochurch 14y ago

Efficient Market Hypothesis isn't very well defined. It's more like a class of assertions, some of which are demonstrably true and some of which are false. Loosely speaking, it says the market price of an asset (or exchange rate between two assets) will be fair, which means that it corresponds to the expected value of its basic value. If you're talking about a bond, you can look at the (known) payment stream, discount the cash flow, and compute a fair value based on known market conditions. For an equity, there is no fair value other than "the expected value of its price in the future". Some stocks pay dividends, but many don't, so their values are based on something other than a current dividend stream, and largely that "something" is: what is the expected value of the thing in the future? The question is: what is the timeframe? In the very short term, EMH is false for computational reasons. Efficient markets require someone (i.e. an arbitrageur) to keep them efficient. The profits of arbitrage are the incentive for people to keep markets as efficient as possible, and they tend to have this effect. This is an extremely competitive business, and in this day in age, it often comes down to microseconds, but it can be done and billions of dollars are made every day by people who are doing it (and, contrary to popular depictions, arbitrage is actually good for the markets and economy). In the very-long term, EHM is probably also false. By very-long, I'm talking about 10+ years. The reason for this is rooted in the scarcity of money: there are a lot of projects and companies that will produce and capture economic value in the future, but people don't have enough money to fund them all. Hence, stocks are "cheaper" than they should be, and risky growth stocks (much less illiquid private equity) especially so. ("Equity premium.") There are some people who (demonstrably) "get" value investing and are better at predicting long-term corporate futures than others. The issue here is the long feedback cycle. If your frequency of investments is that low, you have no way of knowing if you're actually good, or just getting lucky, especially in the context of the non-normal (i.e. fat-tailed) distribution of equity returns driven by "black swan" events. EMH is true enough that if you don't have the technical machinery to trade at microsecond latency, nor the reputation that will allow you to invest for the very long term despite market caprice-- i.e. even if the market tanks, people will trust Warren Buffett's judgment-- you probably can't reliably make a better profit on the stock market than you'd get if you invested in an index fund. What does EMH rely upon? Ultimately, it says that if there is expectancy to be made selling or buying a security at a price other than P, it will be sold or bought until the price reaches P. This assumes an infinite amount of capital ("smart money") that people are willing to deploy in order to exploit pricing inefficiencies or inconsistencies. This is an obviously false assumption, but for liquid securities of known expected value, it's close enough. Leverage (borrowing) generates a lot of "additional" smart money, so that even a 20bp (0.2%) discrepancy can be levered up into a 10% gain. (If you have $100, borrow $4900, and turn that $5,000 into $5,010, your equity position has gone from $100 to $110.) Microprofit opportunities will be exploited so long as there's sufficient leverage to make them worthwhile, but the willingness of lenders is not infinite. EMH is usually used to make mathematical analyses work. It's a guideline, but no one who understands financial markets believes it to be literally and universally true. No one can actually predict the future or human behavior, but the (false) assumption that there is no arbitrage produces closed-form numbers that are often very close to the real values. Also necessary is the distinction between smart and dumb money. The latter isn't a pejorative; "dumb money" means that there are incentives other than informed speculation. For example, when you buy a house because you want to live somewhere, that's dumb money. Or when an index fund buys stocks because of its chartered requirement to do so, that's "dumb money", not because the buyer is an idiot, but because his purchase doesn't convey information about the stock's real value in the way that smart money would. Markets are efficient when there's enough smart money to keep the dumb flow from pushing the price around. This is going to be true of highly liquid stocks, currency rates, and commodities, but not true of assets like real estate. Financial engineers tend to discount "dumb" activity as harmless Brownian motion, but the 2008 subprime mortgage meltdown established that not to be always wise.

drfloob 14y ago

... and if P = NP, the market doesn't matter because everyone will have cracked all your bank passwords.

csense 14y ago

From the paper: > Now, one may argue that a weaker form of market efficiency as per Fama (1991) and Jensen (1978) is that patterns are exploited until the marginal revenue of further discovery equals the marginal cost of further search. A counterargument to that would be graduate students and other hobbyists and day traders searching for an edge: to them, the marginal cost is zero and at times negative because the value of the search itself, regardless of the outcome, is a positive learning experience for them... A hobbyist has to spend more computation time for every additional strategy they search, which costs real money. The hobbyist's cost is near-zero for small searches -- those that can be done by one person using the computers they already own. Once the size of the search increases beyond what they can manage with their immediately available resources, they have to hire assistants and/or buy computation time like anybody else.

josephlord 14y ago

This is I think a bogus debunking of a bogus theory. Try 'Debunking Economics' by Steve Keen for a good breakdown of real problems with many economic theories including EMH. Mostly by showing the logical fallacies in assumptions but also the naive maths and divergence from empirical reality. http://www.amazon.com/Debunking-Economics-Expanded-Dethroned-ebook/dp/B006BG8UFY/ref=sr_1_1?s=digital-text&ie=UTF8&qid=1348943992&sr=1-1&keywords=steve+keen http://www.amazon.com/Debunking-Economics-Expanded-Dethroned... His blog is http://www.debtdeflation.com/blogs/ http://www.debtdeflation.com/blogs/