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If the market is "stupid", what testable results do we expect? Here's one: smart people who figure out better ways to allocate money should be able to consisten

by enoch_r 13y ago

If the market is "stupid", what testable results do we expect? Here's one: smart people who figure out better ways to allocate money should be able to consistently beat the market performance. Great--now let's test that hypothesis! Studies have consistently shown there is very little or no autocorrelation between excess returns--that is, someone who beats the market in year n is essentially no more likely to beat the market in year n+1 than anyone else. This is very different than a field like programming or basketball, where someone who performs well one year will probably perform well the next year. To me, this is absurdly good evidence that the market is not "stupid," even when I think it is. Worse, arguments like this don't merely say that the market is stupid and could be beaten--they use the author's personal views on the stupidity of particular market movements to make that claim. In other words, to accept this argument, I need to believe that you are one of the (maybe) few people on the planet who can consistently beat the market. I don't believe that.

grey-area 13y ago
If the market is "stupid", what testable results do we expect? Here's one: smart people who figure out better ways to allocate money should be able to consistently beat the market performance. Markets behaving irrationally/stupidly != Markets behaving predictably So I disagree that if markets are stupid (irrational is a better word, but stupid would do) other people in the know could take advantage of them. Just because a given person cannot predict the movements of the market, that doesn't mean the market encodes some special unknown information or is in some aggregate sense smarter or more informed than that person. If the market moves essentially randomly in the short term, the most informed person would not have much chance of beating it. The market doesn't need to be clever to beat you, on the contrary, often it beats people by persisting in stupidity for much longer than they thought possible, or longer than they have time for, until they give in and invest, and then perhaps soon after it reverts to something resembling rational for a short while. That's not to mention the many ways in which our stock markets and other markets are rigged and stacked by insiders (insider trading, market manipulation, LIBOR, forex etc). So your contention that you'd need to be incredibly talented to 'beat the market' as you put it isn't very convincing - there is another explanation for the studies you cite - almost no-one is able to consistently beat the market, except by luck. I suspect (though it is just supposition), that markets are the average of all the uninformed and panicky humans who make them up, and that in those crowds of investors and speculators you'll find a madding mill of people all looking for the main chance which oscillates in a chaotic manner, not a huge collective wisdom which outshines everyone on the planet.
- enoch_r 13y ago
  The GP's claim was that: > The rich are simply not smart enough to intelligently allocate their capital. [...] You don't see big investments in new technology, science, infrastructure, or other complex and difficult areas because by and large the financiers do not understand these things. To me, this is saying: tech, science, and infrastructure and undercapitalized relative to their expected returns. It is very difficult for me to construct a model in which a) capital is foolishly providing too little capital to certain sectors relative to the returns it should get, and b) those sectors don't provide outsized returns to the capital they do get. Of course, such a model is possible! It's possible that returns are random but allocations are still irrational. But what does such a model look like? One possibility is that returns are totally unrelated to the underlying performance of an asset. For example: new technology is a more rational allocation of capital, and would provide greater return, but it doesn't, because return is totally disconnected from the performance of the technology. To me, that possibility seems quite unlikely. Yes, the anti-EMH position holds that prices frequently depart from their underlying value--but the idea that there is zero connection, as would be required by such a model, is not tenable. It's absolutely clear that real-world events have effects on asset prices. If, say, Oculus Rift becomes extremely popular with consumers, the capital that invested in it will receive large returns. Another possibility is that there are network effects that make it impossible to make the excess returns from these sectors unless the rest of the financial sector decides to invest in these sectors as well. But it's very difficult to see what those network effects might be, and it's even more difficult to imagine that they are present for all productive investments in these sectors. Unpredictability of asset returns is the primary testable prediction of the EMH. On the other hand, it is difficult to construct a reasonable anti-EMH position that incorporates the observed unpredictability of asset returns. Finally, if the claim that the market is ignoring great opportunities because of stupidity or irrationality does not imply that there are excess returns available on investments in those great opportunities, it's frankly difficult to see what the claim means. If I say "you should invest in my startup, because it's a more intelligent allocation of your capital than real estate--but no, I do not expect that you'll earn higher returns from my startup than you would from another investment," it's pretty difficult to understand what I actually mean by "more intelligent allocation."
Spooky23 13y ago
The "market" isn't just the stock market. Plenty of people and companies are able to earn very high returns on investments. Anywhere there is information asymmetry or control of who can sell what is an opportunity to make lots of money. People can and do beat markets by all sorts of means. People earn 40% annual returns by operating laundromats! The market is only smart when you're selling goods that have well-defined characteristics and retain value irregardless of time and place. Cold water is worth about $0.003 a cup from my tap, but $5 in a bottle at a major league baseball game.
- nickff 13y ago
  >"The market is only smart when you're selling goods that have well-defined characteristics and retain value irregardless of time and place. Cold water is worth about $0.003 a cup from my tap, but $5 in a bottle at a major league baseball game." The water vendors at baseball games are actually a counter-example to what you are trying to show. Though the water bottles are expensive, no one in the supply chain is able to make very much money (at most stadiums) without government intervention. The water vendors are forced to either work for the stadium at a low wage, buy the water at a high price from the stadium, or pay a hefty rent to the venue. The stadium is in turn not making much (if any) money at all without government intervention; this is why they are always lobbying for special tax breaks, zoning laws, and government-subsidized loans. The water bottle suppliers and producers are in turn competing against each other in a cut-throat business, with razor thin margins.
  - Spooky23 13y ago
    I think you're over analyzing the example. The point is that a cold water on a hot day is worth more. A pure commodity like gravel or dirt is different, the price of a particular grade of the commodity is purely based on demand and shipping.
    - nickff 13y ago
      I think your example proved that the market works surprisingly well, even when subjected to numerous constraints.
genofon 13y ago
No autocorrelation with excess return can also be explained with randomness.. it demonstrate that the markets are not stupid as much as they are. markets can stay irrational longer than you can stay solvent - Warren Buffet
Tossrock 13y ago
Which studies do you refer to? And how do you explain top VC firms consistently getting much higher returns on funds than, say, the DJI?
- nickff 13y ago
  "Luck versus Skill in the Cross-Section of Mutual Fund Returns" By Eugene F Fama and Kenneth R French http://faculty.chicagobooth.edu/john.cochrane/teaching/35150_advanced_investments/Luck%20versus%20Skilll%20in%20the%20Cross%20Section%20of%20Mutual%20Fund%20Returns.pdf http://faculty.chicagobooth.edu/john.cochrane/teaching/35150...
Florin_Andrei 13y ago
> Studies have consistently shown there is very little or no autocorrelation between excess returns--that is, someone who beats the market in year n is essentially no more likely to beat the market in year n+1 than anyone else. This is very different than a field like programming or basketball, where someone who performs well one year will probably perform well the next year. > To me, this is absurdly good evidence that the market is not "stupid," even when I think it is. Or it could be evidence that the game is essentially random, and that intelligence is not a differentiating factor.

by enoch_r 13y ago

If the market is "stupid", what testable results do we expect? Here's one: smart people who figure out better ways to allocate money should be able to consistently beat the market performance. Great--now let's test that hypothesis! Studies have consistently shown there is very little or no autocorrelation between excess returns--that is, someone who beats the market in year n is essentially no more likely to beat the market in year n+1 than anyone else. This is very different than a field like programming or basketball, where someone who performs well one year will probably perform well the next year. To me, this is absurdly good evidence that the market is not "stupid," even when I think it is. Worse, arguments like this don't merely say that the market is stupid and could be beaten--they use the author's personal views on the stupidity of particular market movements to make that claim. In other words, to accept this argument, I need to believe that you are one of the (maybe) few people on the planet who can consistently beat the market. I don't believe that.

grey-area 13y ago

If the market is "stupid", what testable results do we expect? Here's one: smart people who figure out better ways to allocate money should be able to consistently beat the market performance. Markets behaving irrationally/stupidly != Markets behaving predictably So I disagree that if markets are stupid (irrational is a better word, but stupid would do) other people in the know could take advantage of them. Just because a given person cannot predict the movements of the market, that doesn't mean the market encodes some special unknown information or is in some aggregate sense smarter or more informed than that person. If the market moves essentially randomly in the short term, the most informed person would not have much chance of beating it. The market doesn't need to be clever to beat you, on the contrary, often it beats people by persisting in stupidity for much longer than they thought possible, or longer than they have time for, until they give in and invest, and then perhaps soon after it reverts to something resembling rational for a short while. That's not to mention the many ways in which our stock markets and other markets are rigged and stacked by insiders (insider trading, market manipulation, LIBOR, forex etc). So your contention that you'd need to be incredibly talented to 'beat the market' as you put it isn't very convincing - there is another explanation for the studies you cite - almost no-one is able to consistently beat the market, except by luck. I suspect (though it is just supposition), that markets are the average of all the uninformed and panicky humans who make them up, and that in those crowds of investors and speculators you'll find a madding mill of people all looking for the main chance which oscillates in a chaotic manner, not a huge collective wisdom which outshines everyone on the planet.

enoch_r 13y ago
The GP's claim was that: > The rich are simply not smart enough to intelligently allocate their capital. [...] You don't see big investments in new technology, science, infrastructure, or other complex and difficult areas because by and large the financiers do not understand these things. To me, this is saying: tech, science, and infrastructure and undercapitalized relative to their expected returns. It is very difficult for me to construct a model in which a) capital is foolishly providing too little capital to certain sectors relative to the returns it should get, and b) those sectors don't provide outsized returns to the capital they do get. Of course, such a model is possible! It's possible that returns are random but allocations are still irrational. But what does such a model look like? One possibility is that returns are totally unrelated to the underlying performance of an asset. For example: new technology is a more rational allocation of capital, and would provide greater return, but it doesn't, because return is totally disconnected from the performance of the technology. To me, that possibility seems quite unlikely. Yes, the anti-EMH position holds that prices frequently depart from their underlying value--but the idea that there is zero connection, as would be required by such a model, is not tenable. It's absolutely clear that real-world events have effects on asset prices. If, say, Oculus Rift becomes extremely popular with consumers, the capital that invested in it will receive large returns. Another possibility is that there are network effects that make it impossible to make the excess returns from these sectors unless the rest of the financial sector decides to invest in these sectors as well. But it's very difficult to see what those network effects might be, and it's even more difficult to imagine that they are present for all productive investments in these sectors. Unpredictability of asset returns is the primary testable prediction of the EMH. On the other hand, it is difficult to construct a reasonable anti-EMH position that incorporates the observed unpredictability of asset returns. Finally, if the claim that the market is ignoring great opportunities because of stupidity or irrationality does not imply that there are excess returns available on investments in those great opportunities, it's frankly difficult to see what the claim means. If I say "you should invest in my startup, because it's a more intelligent allocation of your capital than real estate--but no, I do not expect that you'll earn higher returns from my startup than you would from another investment," it's pretty difficult to understand what I actually mean by "more intelligent allocation."

Spooky23 13y ago

The "market" isn't just the stock market. Plenty of people and companies are able to earn very high returns on investments. Anywhere there is information asymmetry or control of who can sell what is an opportunity to make lots of money. People can and do beat markets by all sorts of means. People earn 40% annual returns by operating laundromats! The market is only smart when you're selling goods that have well-defined characteristics and retain value irregardless of time and place. Cold water is worth about $0.003 a cup from my tap, but $5 in a bottle at a major league baseball game.

nickff 13y ago
>"The market is only smart when you're selling goods that have well-defined characteristics and retain value irregardless of time and place. Cold water is worth about $0.003 a cup from my tap, but $5 in a bottle at a major league baseball game." The water vendors at baseball games are actually a counter-example to what you are trying to show. Though the water bottles are expensive, no one in the supply chain is able to make very much money (at most stadiums) without government intervention. The water vendors are forced to either work for the stadium at a low wage, buy the water at a high price from the stadium, or pay a hefty rent to the venue. The stadium is in turn not making much (if any) money at all without government intervention; this is why they are always lobbying for special tax breaks, zoning laws, and government-subsidized loans. The water bottle suppliers and producers are in turn competing against each other in a cut-throat business, with razor thin margins.
- Spooky23 13y ago
  I think you're over analyzing the example. The point is that a cold water on a hot day is worth more. A pure commodity like gravel or dirt is different, the price of a particular grade of the commodity is purely based on demand and shipping.
  - nickff 13y ago
    I think your example proved that the market works surprisingly well, even when subjected to numerous constraints.

genofon 13y ago

No autocorrelation with excess return can also be explained with randomness.. it demonstrate that the markets are not stupid as much as they are. markets can stay irrational longer than you can stay solvent - Warren Buffet

Tossrock 13y ago

Which studies do you refer to? And how do you explain top VC firms consistently getting much higher returns on funds than, say, the DJI?

nickff 13y ago
"Luck versus Skill in the Cross-Section of Mutual Fund Returns" By Eugene F Fama and Kenneth R French http://faculty.chicagobooth.edu/john.cochrane/teaching/35150_advanced_investments/Luck%20versus%20Skilll%20in%20the%20Cross%20Section%20of%20Mutual%20Fund%20Returns.pdf http://faculty.chicagobooth.edu/john.cochrane/teaching/35150...

Florin_Andrei 13y ago

> Studies have consistently shown there is very little or no autocorrelation between excess returns--that is, someone who beats the market in year n is essentially no more likely to beat the market in year n+1 than anyone else. This is very different than a field like programming or basketball, where someone who performs well one year will probably perform well the next year. > To me, this is absurdly good evidence that the market is not "stupid," even when I think it is. Or it could be evidence that the game is essentially random, and that intelligence is not a differentiating factor.