One of the underlying principles of finance is the efficient market hypothesis (EMH), or a semi-strong version thereof*.
The EMH says that all relevant information about a share/bond/commodity/index gets rapidly absorbed by the market (being the group of investors interested that particular asset) and included in the quoted price. The price thus becomes the great signal of what everyone thinks the share is worth.
Now if you accept that the EMH is true, then there are some implications:
- If the market knows everything already, then all share prices are correctly valued at any point in time;
- Movements in the share price arise because the market is assimilating new information;
- Because you cannot know the new information before the market, there is no possible skill you can have in picking stocks – apart from hunches, gut feelings, insider trading**, and witchcraft; therefore
- You should trade passively at all times. That is: just buy the stock index.
Generally speaking, there are studies out there that support this. And then: there are anomalies like Warren Buffett.
I confess that I like the idea of EMH. It lets me look down upon the traders and the fund managers and know that there is just no way that they know better than me. But if I back out of the finance-economics mindset and pretend that I’m just home-spun, I would ask some human nature questions:
Surely you can’t know everything?
I, for one, cannot speak much Russian. Nor do I know very much about nanotechnology. Or the uses of polonium.
And as for the “two heads better than one” / “division of knowledge” argument – I present the counter empirically. Which is to say: economists do not actually deal with the information-absorption capabilities of the market – unlike politicians…
Well: politicians spend most of their time attempting to dumb down their tax policies and make it accessible to the illiterate and uncomprehending masses. I mean – to the point where Obama’s tax-plan was “not Mitt Romney’s”. At which point, they stop bothering, and just leap on the gay marriage bandwagon and play the social issues card.
No – the market is hardly the oracular repository of comprehending intelligence. Individually, we may know a few things about a few things. Collectively: we know almost nothing about anything at all. And then vote for the good-looking guy, if we even remember to vote.
In order to accept the EMH, I think you’d have to accept that “knowledge” means “all that is knowable to George Bush Jr.”. And that it is not possible for anyone to know any more than him.
And even if you know everything, surely you can’t understand everything?
I can know exactly how my wife/parent/partner will react in a given situation – but please don’t ask me why. Because I can’t always explain why they react the way they do.
There is fundamental problem of objectivity. All knowledge is subjective.
What about the fact that not everything is true?
Also, bitches be liars. And manipulating you to their own ends. I refer you back to the politicians above; and any trader that just shorted stock.
The Immediate Response
At the risk of getting too philosophical – we come down to the question of “what is knowledge?” In some instances, knowledge is fact. In most instances, we confuse knowledge with belief.
In which case, the EMH really just says that the price is the point at which our individual beliefs about our collective wants and needs intersect.
And the implication of this is that people need to be clearer about the bet that they take on a stock market, because it’s not enough to say that the stock market is wrong about the price.
You have to believe that:
- the market is wrong about the price AND
- the market will get it right at some point in the future (ie. converge to your point of view) AND
- nothing will happen in the interim to make your current belief irrelevant.
Which adds up to less than a 50-50 chance that you’re right***. At best, there’s just a 50-50 chance that your purchase might inadvertently earn you a return.
*There are multiple versions of the EMH. The strong version says that all information is included in the price instantly. The semi-strong says that the important and public information is included in the price pretty quickly. The weak version basically says that the market doesn’t know everything. There is good statistical evidence, if that’s what you’re into, that the market demonstrates the semi-strong version of EMH most of the time. Of course – there are clear examples where it doesn’t. The Subprime Mortgage saga, for instance, caught most of the market off-guard. Despite the fact that the information required to get the right pricing was openly available to anyone looking for it.
**Under strong EMH, even inside information is considered to be already included in the stock price.
***The probability math: let’s say that there’s a 50% chance that you’re right about the market being wrong. There’s also a 50% chance that the market will realize that it got it wrong. And there’s a 50% chance that nothing will happen in the interim to make your opinion irrelevant. There’s therefore a 50% x 50% x 50% = 12.5% chance that you’ll have made the right call…