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An Infinite Regress. Of Dumb: More Reflections on “Market Efficiency”

54 points by nkurz 12y ago

carsongross 12y ago
The current and long-running debt and capital gains driven financial asset market has made everyone insane. If valuations were based on tangible cash flows (dividends paid out of profits) then the question of how much stocks are worth becomes far less insanely self-referential. Real markets work on markup-based pricing and cash flow from profits. See Steve Keen's work[1]. In a world where the banking system can introduce nearly infinite leverage into any financial transaction (see student loans) what's the price of anything? [1] - http://www.amazon.com/Debunking-Economics-Revised-Expanded-Dethroned/dp/1848139926 http://www.amazon.com/Debunking-Economics-Revised-Expanded-D...
- grandalf 12y ago
  That is true, but I think the counter-argument is that the Fed does much of what it does to create price stability, not price accuracy. Prices should be generally stable in the face of everything but supply and demand shifts brought upon by technological change and competition. If the price of a car rose/fell 20% "accurately" (per your comment) every few years people would have to hedge against the risks that those price fluctuations would cause. Our system reduces the need to worry about such risks b/c they are viewed as unnecessary noise. In other words, when prices are generally stable we can plan for the future rather than hedging against the impact of random (though market-based) price volatility.
- JimboOmega 12y ago
  I agree with your complaint, generally. One thing I often wonder about is the value of Facebook stock. It has effectively no voting rights (Because of Zuckerberg's control), and I can't imagine Facebook issuing a dividend... so what rights does it really have? How do you value something like that?
  - carsongross 12y ago
    Exactly. It's the modern world's equivalent of debating the number of angels capable of dancing on a pinhead. You have these chumps talking about future cash flows and dividend yield equivalents, all the while the board and executives march off with the actual cash. The right thing is to eliminate the tax bias towards capital gains and make dividends tax-deductible for corporations, so they have incentive to pay profits out to, you know, the owners. Basically make them act like big LLCs, which is the fair thing: why should Grandma Jones pay the same corporate rate as Mitt Romney on her investments in Coca Cola before she sees a dime? At some point it'll reverse, but it's been a good forty years, so... who knows?
  - meric 12y ago
    In the future when Zuckerberg is finally willing to pay a dividend or he is replaced by a board willing to pay a dividend when he retires. It's hard to value that's why the value of Facebook stock is so volatile.
- vasilipupkin 12y ago
  valuations are based not just on current cashflows, but future expected cashflows. That's why leverage is so crucial - it allows us to borrow against future cashflows so as to finance projects today. One way to think about, on this forum, we can agree that at some point in the future, we will have self driving cars, automated medicine, low cost energy etc. So, what we can do is borrow against that future to build stuff today
  - carsongross 12y ago
    Yes, I understand productive debt and I have no beef with it (so long as no one is coerced into bailing out bad loans, which, of course, is constantly happening in the name of "systemic stability.") If you think this has anything to do with the huge debt overhang in western societies... Well, I have an efficient market to sell you. Read Keen. He explains it very well.
exelius 12y ago
When doing any sort of theoretical work in finance or economics, academics often make the assumption that markets are rational and efficient. This assumption is almost universally false. They know that markets are neither: markets may or may not be rational (we can never realistically gather enough data to know thanks to information asymmetry) and they certainly aren't 100% efficient over most timelines. Just because the assumption is wrong doesn't mean it's not useful: without it, you can't even build a reasonable model of financial markets. But because the assumption is core to financial modeling, this means that all financial models are wrong. In fact, that's exactly how my financial modeling professor opened up the first class: by explicitly stating that all models are wrong in some way. You have to understand the ways that the model can be wrong in order to make any substantive claims about it. The Black-Shoals options pricing model assumes market liquidity; it's not very useful if you're talking about an asset that isn't very liquid. Misunderstanding when models should and should not be applied is one of the core reasons we got into an asset bubble in the mid-2000s. Banks were pricing financial products using models whose assumptions did not hold over the long-term. They didn't understand how their models were wrong until it was too late, and it ended up losing them (but ultimately the American taxpayers) a lot of money. But because the assumption that markets are always rational and efficient is wrong, it doesn't follow that markets are never rational or efficient. Markets can be rational and efficient, but it depends on the relative timeframe and the structure of the market involved.
- aetherson 12y ago
  Newtonian mechanics is wrong. It's wrong, wrong, wrong, wrong, wrong. We know it's wrong, and we've known for about a century now. But it turns out that it's still a good idea to teach Newtonian mechanics -- it's a useful model, as long as you know its limitations.
  - mikeash 12y ago
    It's wrong in some scenarios, but it's still correct (to within many, many decimal places) in many others. Theories and models aren't just right or wrong. Some are more wrong than others. Isaac Asimov summed it up better than I could: http://chem.tufts.edu/answersinscience/relativityofwrong.htm http://chem.tufts.edu/answersinscience/relativityofwrong.htm Newtonian mechanics isn't so much wrong as it is incomplete. Is anything in economics like that? It doesn't seem so.
ScottBurson 12y ago
It's pretty easy to guess how the EMH got started: economics professors tried to trade the markets and got their heads handed to them in thin slices. Their egos, thus battered, created an excuse. What they didn't understand is that trading is a competitive game of skill: mere intelligence is not sufficient, any more than it would be if they walked onto a tennis court with Roger Federer.
- exelius 12y ago
  This is totally wrong; there's very little skill involved in trading. Any university student with a basic knowledge of calculus can learn all there is to know about the markets from a skill perspective in a year or less. In fact, this is exactly why the big investment banks prefer to hire kids fresh out of college. Where companies really make a lot of money is on the relationships. Goldman Sachs doesn't make $500 million off an IPO because they're better at drafting SEC paperwork than anyone else; they make that money because they have thousands of clients with money to invest that they can call and convince to fund the IPO.
  - ScottBurson 12y ago
    > This is totally wrong; there's very little skill involved in trading. Not only are you badly misinformed, you are spreading information that could encourage someone to risk their money when they don't know what they're doing. First off, something that requires a university education and a year of full-time training is not what most people think of when they hear the phrase "very little skill involved". When a member of the general public tries trading for the first time, they have far less than even that (and even economics professors have less of it than they think.) Secondly, what you're describing is algorithmic trading, not discretionary trading. I guarantee you that that math whiz fresh out of college is not allowed to risk significant amounts of money on personal hunches. (I would guess they don't learn discretionary trading at all; they have their hands full with the algorithms.) I'm sure there's a lot of infrastructure to ensure that any strategy they come up with is well back-tested before going live. Again, the general public (including the professors) isn't doing algo trading and doesn't have access to that infrastructure and that support system. Tennis was not the best analog. Trading is more like poker. First, they both have the property that the more you win, the bigger advantage you have, and conversely. Second, as they say, if you don't know who the sucker at the table is, it's you.
aetherson 12y ago
Has the author of that post every given the Beauty Contest game to the same group of people three times in a row? What happens then?
- discodave 12y ago
  No but that has been done in the experimental economics literature: http://web.stanford.edu/~niederle/GuessingGames.pdf http://web.stanford.edu/~niederle/GuessingGames.pdf (see slide 11) The answer is: the mean gradually approaches zero.
- derriz 12y ago
  Indeed the article is poor. His beauty contest results are more plausibly explained by anchoring bias (start at 2 thirds of 100). EMH is about price dynamics so a single "run" of the beauty contest says nothing about it. I am willing to bet a significant amount that after a couple of iterations, the bids would go to zero. I simply dont see The "paradox" the author thinks they have discovered. There is reams of empirical evidence that active fund management is GENERALLY a losing proposition for savers. Both parties to a trade can end up losers because trading costs are never zero. If you want to go quickly broke, just keep blindly buying and selling over and over. Even if you beat the spread, the fees will swallow your money.
codeflo 12y ago
Making fun of economists who assume efficient markets is a lot like making fun of physicists who assume frictionless motion. Or computer scientists who assume an infinite Turing tape. Simplifying assumptions can be very useful if you know their limitations. It seems that in the author's beauty contest game, most people are unable to analyze this game correctly at the top of their head. Maybe some people don't even bother and just pick any random number. But assume that this game is played repeatedly and for real money (like in a stock market). I think people will notice that low numbers consistently win, which will cause a downward trend towards the Nash equilibrium in very few iterations.
- vasilipupkin 12y ago
  precisely. In fact, you see it in the markets, even among quantitative Phds, only a very small fraction beats the market. It's broadly efficient, on long enough time scales. It's inefficient on extremely short time scales, which is why HFT works so well.
- mikeash 12y ago
  If physicists never turned "frictionless motion" assumptions into useful, accurate predictions, I see no reason not to make fun of them. Physics has a long history of extreme success. Economics, on the other hand, often has more opinions than practitioners, and no physics-level accurate predictions in sight.
bradleyjg 12y ago
About three quarters of the way down, the author draws these conclusions from a classic 1980 paper: - there is smart money in the market, - the smart money can and is outperforming right now, but that smart money isn't YOU, - so sit down and index. I don't mean to be anti-intellectual, the various versions of the EMH and the responses to them are interesting, important concerns in the study of finance and economics. But the take away for the vast majority of the public should be the above. The market may or may not be efficient but you aren't going to beat it. And even if someone else can, he isn't going to use that ability for your benefit.
- meric 12y ago
  I think what it means any money can be "smart money"[1], but over a longer horizon, no money can be consistently smart. [1] If you work in a company you're well placed than most in judging the value of the company. Yes there are regulations to prevent you from insider trading, but no it doesn't mean you can't invest in the company (or short it!) on the basis you know your colleagues better than others. You, however, have no advantage over the market over all other forms of investment.
deleted 12y ago
[deleted]
lordnacho 12y ago
When you do find an alpha, it tends to exist for some systemic reason. The financial system is organized in some way that systematically presents opportunities to make money. It may have to do with slowness of large players, information leakage from weak order placement systems, ideological disposition towards disregarding some phenomenon, etc. The way to think about it is not some efficient calculating machine, but as an ecosystem. Can you imagine a tiger saying "hey, there's more prey here than I need to eat and reproduce. Must be something wrong with the system"? No, he just eats and shags. Evolution keeps things in check, meaning things don't go obviously out of whack, but now and again local imbalances occur that can be exploited. The fact that they are exploited also obscures their existence from a high level.
codeulike 12y ago
I've got a tangential question about efficiency that someone might be able to help with: The perceived wisdom is that capitalist systems result in efficient companies, because they beat the inefficient ones. So for example we have Apple making tons of money because they were better at what they were doing than (most) of their competitors. So the end result of a bunch of competition is an efficient company ... but how efficient was the process of getting to that end result? So for example once you count all the failed competitors in a given market, the bankruptcies, redundancies, people who invested their time and money in failing businesses. Has anyone measured the overall 'efficiency' of a competitive system whittling down the competitors to the viable ones? Is there a name for this concept in economics? I'm wondering because efficient end result =/= efficient process, and the process itself must have a cost to society etc.
jsprogrammer 12y ago
> the hypothesis that there is no information in the past history of share prices which can be used to predict the future A belief in that hypothesis strikes me as particularly delusional. The strongest indicator of what a share price will be at `t+1` is what the share price is at `t+0`. Why would anyone delude themselves otherwise? Maybe that would hold true if execution prices are never revealed (not even to the participants of a trade), but prices are streamed out constantly and are exactly what traders are interested in (how else can they measure their 'gains' and 'losses'?).
- kpommerenke 12y ago
  A market is weak-form efficient if you cannot use past share prices to predict the direction of future price changes. Or in other words, if you can't use past returns to predict future returns. There's no delusion.
  - jsprogrammer 12y ago
    Direction of change is a bit different from future price and I don't believe was considered in this treatment.

54 points by nkurz 12y ago

The current and long-running debt and capital gains driven financial asset market has made everyone insane. If valuations were based on tangible cash flows (dividends paid out of profits) then the question of how much stocks are worth becomes far less insanely self-referential. Real markets work on markup-based pricing and cash flow from profits. See Steve Keen's work[1]. In a world where the banking system can introduce nearly infinite leverage into any financial transaction (see student loans) what's the price of anything? [1] - http://www.amazon.com/Debunking-Economics-Revised-Expanded-Dethroned/dp/1848139926 http://www.amazon.com/Debunking-Economics-Revised-Expanded-D...

grandalf 12y ago
That is true, but I think the counter-argument is that the Fed does much of what it does to create price stability, not price accuracy. Prices should be generally stable in the face of everything but supply and demand shifts brought upon by technological change and competition. If the price of a car rose/fell 20% "accurately" (per your comment) every few years people would have to hedge against the risks that those price fluctuations would cause. Our system reduces the need to worry about such risks b/c they are viewed as unnecessary noise. In other words, when prices are generally stable we can plan for the future rather than hedging against the impact of random (though market-based) price volatility.
JimboOmega 12y ago
I agree with your complaint, generally. One thing I often wonder about is the value of Facebook stock. It has effectively no voting rights (Because of Zuckerberg's control), and I can't imagine Facebook issuing a dividend... so what rights does it really have? How do you value something like that?
- carsongross 12y ago
  Exactly. It's the modern world's equivalent of debating the number of angels capable of dancing on a pinhead. You have these chumps talking about future cash flows and dividend yield equivalents, all the while the board and executives march off with the actual cash. The right thing is to eliminate the tax bias towards capital gains and make dividends tax-deductible for corporations, so they have incentive to pay profits out to, you know, the owners. Basically make them act like big LLCs, which is the fair thing: why should Grandma Jones pay the same corporate rate as Mitt Romney on her investments in Coca Cola before she sees a dime? At some point it'll reverse, but it's been a good forty years, so... who knows?
- meric 12y ago
  In the future when Zuckerberg is finally willing to pay a dividend or he is replaced by a board willing to pay a dividend when he retires. It's hard to value that's why the value of Facebook stock is so volatile.
vasilipupkin 12y ago
valuations are based not just on current cashflows, but future expected cashflows. That's why leverage is so crucial - it allows us to borrow against future cashflows so as to finance projects today. One way to think about, on this forum, we can agree that at some point in the future, we will have self driving cars, automated medicine, low cost energy etc. So, what we can do is borrow against that future to build stuff today
- carsongross 12y ago
  Yes, I understand productive debt and I have no beef with it (so long as no one is coerced into bailing out bad loans, which, of course, is constantly happening in the name of "systemic stability.") If you think this has anything to do with the huge debt overhang in western societies... Well, I have an efficient market to sell you. Read Keen. He explains it very well.

exelius 12y ago

When doing any sort of theoretical work in finance or economics, academics often make the assumption that markets are rational and efficient. This assumption is almost universally false. They know that markets are neither: markets may or may not be rational (we can never realistically gather enough data to know thanks to information asymmetry) and they certainly aren't 100% efficient over most timelines. Just because the assumption is wrong doesn't mean it's not useful: without it, you can't even build a reasonable model of financial markets. But because the assumption is core to financial modeling, this means that all financial models are wrong. In fact, that's exactly how my financial modeling professor opened up the first class: by explicitly stating that all models are wrong in some way. You have to understand the ways that the model can be wrong in order to make any substantive claims about it. The Black-Shoals options pricing model assumes market liquidity; it's not very useful if you're talking about an asset that isn't very liquid. Misunderstanding when models should and should not be applied is one of the core reasons we got into an asset bubble in the mid-2000s. Banks were pricing financial products using models whose assumptions did not hold over the long-term. They didn't understand how their models were wrong until it was too late, and it ended up losing them (but ultimately the American taxpayers) a lot of money. But because the assumption that markets are always rational and efficient is wrong, it doesn't follow that markets are never rational or efficient. Markets can be rational and efficient, but it depends on the relative timeframe and the structure of the market involved.

aetherson 12y ago
Newtonian mechanics is wrong. It's wrong, wrong, wrong, wrong, wrong. We know it's wrong, and we've known for about a century now. But it turns out that it's still a good idea to teach Newtonian mechanics -- it's a useful model, as long as you know its limitations.
- mikeash 12y ago
  It's wrong in some scenarios, but it's still correct (to within many, many decimal places) in many others. Theories and models aren't just right or wrong. Some are more wrong than others. Isaac Asimov summed it up better than I could: http://chem.tufts.edu/answersinscience/relativityofwrong.htm http://chem.tufts.edu/answersinscience/relativityofwrong.htm Newtonian mechanics isn't so much wrong as it is incomplete. Is anything in economics like that? It doesn't seem so.

ScottBurson 12y ago

It's pretty easy to guess how the EMH got started: economics professors tried to trade the markets and got their heads handed to them in thin slices. Their egos, thus battered, created an excuse. What they didn't understand is that trading is a competitive game of skill: mere intelligence is not sufficient, any more than it would be if they walked onto a tennis court with Roger Federer.

exelius 12y ago
This is totally wrong; there's very little skill involved in trading. Any university student with a basic knowledge of calculus can learn all there is to know about the markets from a skill perspective in a year or less. In fact, this is exactly why the big investment banks prefer to hire kids fresh out of college. Where companies really make a lot of money is on the relationships. Goldman Sachs doesn't make $500 million off an IPO because they're better at drafting SEC paperwork than anyone else; they make that money because they have thousands of clients with money to invest that they can call and convince to fund the IPO.
- ScottBurson 12y ago
  > This is totally wrong; there's very little skill involved in trading. Not only are you badly misinformed, you are spreading information that could encourage someone to risk their money when they don't know what they're doing. First off, something that requires a university education and a year of full-time training is not what most people think of when they hear the phrase "very little skill involved". When a member of the general public tries trading for the first time, they have far less than even that (and even economics professors have less of it than they think.) Secondly, what you're describing is algorithmic trading, not discretionary trading. I guarantee you that that math whiz fresh out of college is not allowed to risk significant amounts of money on personal hunches. (I would guess they don't learn discretionary trading at all; they have their hands full with the algorithms.) I'm sure there's a lot of infrastructure to ensure that any strategy they come up with is well back-tested before going live. Again, the general public (including the professors) isn't doing algo trading and doesn't have access to that infrastructure and that support system. Tennis was not the best analog. Trading is more like poker. First, they both have the property that the more you win, the bigger advantage you have, and conversely. Second, as they say, if you don't know who the sucker at the table is, it's you.

aetherson 12y ago

Has the author of that post every given the Beauty Contest game to the same group of people three times in a row? What happens then?

discodave 12y ago
No but that has been done in the experimental economics literature: http://web.stanford.edu/~niederle/GuessingGames.pdf http://web.stanford.edu/~niederle/GuessingGames.pdf (see slide 11) The answer is: the mean gradually approaches zero.
derriz 12y ago
Indeed the article is poor. His beauty contest results are more plausibly explained by anchoring bias (start at 2 thirds of 100). EMH is about price dynamics so a single "run" of the beauty contest says nothing about it. I am willing to bet a significant amount that after a couple of iterations, the bids would go to zero. I simply dont see The "paradox" the author thinks they have discovered. There is reams of empirical evidence that active fund management is GENERALLY a losing proposition for savers. Both parties to a trade can end up losers because trading costs are never zero. If you want to go quickly broke, just keep blindly buying and selling over and over. Even if you beat the spread, the fees will swallow your money.

codeflo 12y ago

Making fun of economists who assume efficient markets is a lot like making fun of physicists who assume frictionless motion. Or computer scientists who assume an infinite Turing tape. Simplifying assumptions can be very useful if you know their limitations. It seems that in the author's beauty contest game, most people are unable to analyze this game correctly at the top of their head. Maybe some people don't even bother and just pick any random number. But assume that this game is played repeatedly and for real money (like in a stock market). I think people will notice that low numbers consistently win, which will cause a downward trend towards the Nash equilibrium in very few iterations.

vasilipupkin 12y ago
precisely. In fact, you see it in the markets, even among quantitative Phds, only a very small fraction beats the market. It's broadly efficient, on long enough time scales. It's inefficient on extremely short time scales, which is why HFT works so well.
mikeash 12y ago
If physicists never turned "frictionless motion" assumptions into useful, accurate predictions, I see no reason not to make fun of them. Physics has a long history of extreme success. Economics, on the other hand, often has more opinions than practitioners, and no physics-level accurate predictions in sight.

bradleyjg 12y ago

About three quarters of the way down, the author draws these conclusions from a classic 1980 paper: - there is smart money in the market, - the smart money can and is outperforming right now, but that smart money isn't YOU, - so sit down and index. I don't mean to be anti-intellectual, the various versions of the EMH and the responses to them are interesting, important concerns in the study of finance and economics. But the take away for the vast majority of the public should be the above. The market may or may not be efficient but you aren't going to beat it. And even if someone else can, he isn't going to use that ability for your benefit.

meric 12y ago
I think what it means any money can be "smart money"[1], but over a longer horizon, no money can be consistently smart. [1] If you work in a company you're well placed than most in judging the value of the company. Yes there are regulations to prevent you from insider trading, but no it doesn't mean you can't invest in the company (or short it!) on the basis you know your colleagues better than others. You, however, have no advantage over the market over all other forms of investment.

deleted 12y ago

[deleted]

lordnacho 12y ago

When you do find an alpha, it tends to exist for some systemic reason. The financial system is organized in some way that systematically presents opportunities to make money. It may have to do with slowness of large players, information leakage from weak order placement systems, ideological disposition towards disregarding some phenomenon, etc. The way to think about it is not some efficient calculating machine, but as an ecosystem. Can you imagine a tiger saying "hey, there's more prey here than I need to eat and reproduce. Must be something wrong with the system"? No, he just eats and shags. Evolution keeps things in check, meaning things don't go obviously out of whack, but now and again local imbalances occur that can be exploited. The fact that they are exploited also obscures their existence from a high level.

codeulike 12y ago

I've got a tangential question about efficiency that someone might be able to help with: The perceived wisdom is that capitalist systems result in efficient companies, because they beat the inefficient ones. So for example we have Apple making tons of money because they were better at what they were doing than (most) of their competitors. So the end result of a bunch of competition is an efficient company ... but how efficient was the process of getting to that end result? So for example once you count all the failed competitors in a given market, the bankruptcies, redundancies, people who invested their time and money in failing businesses. Has anyone measured the overall 'efficiency' of a competitive system whittling down the competitors to the viable ones? Is there a name for this concept in economics? I'm wondering because efficient end result =/= efficient process, and the process itself must have a cost to society etc.

jsprogrammer 12y ago

> the hypothesis that there is no information in the past history of share prices which can be used to predict the future A belief in that hypothesis strikes me as particularly delusional. The strongest indicator of what a share price will be at `t+1` is what the share price is at `t+0`. Why would anyone delude themselves otherwise? Maybe that would hold true if execution prices are never revealed (not even to the participants of a trade), but prices are streamed out constantly and are exactly what traders are interested in (how else can they measure their 'gains' and 'losses'?).

kpommerenke 12y ago
A market is weak-form efficient if you cannot use past share prices to predict the direction of future price changes. Or in other words, if you can't use past returns to predict future returns. There's no delusion.
- jsprogrammer 12y ago
  Direction of change is a bit different from future price and I don't believe was considered in this treatment.