Efficient Market Theory

[7Wannabe5]

Do you believe in EMT (efficient market theory) and if so, why would one choose to invest in an efficient market rather than trade in an inefficient market?

[jacob]

Don't you mean "if not"?

[7Wannabe5]

Maybe. Does the theory state that all markets are efficient?

Entirely possible that I do not know what I am talking about, but example of what I am wondering would be something like why would one choose to invest in Mattel stock vs. the collectible Barbie doll market? Is it supposed to be true that the increased hassle of the second is equal to the increased opportunities for finding a good deal?

[George the original one]

Mattel stock pays a dividend, one that is historically growing, so there is a reasonable chance that you will have a continuing income. No market required, apart from your initial purchase!

A collectible, especially a one-off item, is entirely dependent on a liquid market. If you can't find a buyer, you can't realize any income and that income is subject to a one-time sale which can't be repeated. In the meantime, you are going to have expenses for securely storing the collectible.

[7Wannabe5]

Thanks. That was helpful.

[jacob]

@7wb5 - Okay, now I see where you're coming from. Yes, that's supposed to be true (if you accept the hypothesis, that is, not all people do).---That is, that existing inefficiencies remain only because it's not economically worthwhile to pay someone to remove them. When market inefficiencies are removed then the person removing them profits, but he may also have fixed expenses like salary, storage costs, etc. so if the costs exceeds the profit, the inefficiency remains.

The theory doesn't state that markets are efficient. Rather "efficiency" is fundamental (ab initio) assumption to the theory (a bunch of math that is derived from it) and not a conclusion. You can then compare the conclusion to reality and make some inferences about the assumptions.

[KevinW]

Remember that, if you suppose markets are efficient and a particular security is priced efficiently, that doesn't mean it is impossible to profit from that security. It just means that the risk-reward proposition of that security is no better than any other efficiently-priced security. If you buy & hold a share of Mattel then you get one share of Mattel's earnings, which is likely positive, through appreciation and/or dividends. If you buy a Barbie doll then you get the appreciation/depreciation of the doll, likely negative.

[jacob]

@KevinW - I agree that the implication of EMH insofar risk is defined as historic price-variance is that the risk/reward ratio (Sharpe ratio) of all securities are identical. However, is the statistical definition of risk actually part of the EMH? I mean, where does that assumption (that risk = variation of historical prices) come from? Is that part of "canonical EMH" or is that an extra assumption of modern(*) portfolio theory?

(*) Not so modern anymore. It originated in the 1950/60s.

Also, it would mean that it would be impossible to EXPECT to profit. Any profit would be explained by luck (the variation).

Of course it's not hard to find people who have profited to a degree that's extremely unlikely (impossible) to have been due to luck alone. See e.g. Jack Schwager's Market Wizards series. But that's more a matter of whether the EMH is correct in the first place. Separate issue.

[7Wannabe5]

Okay, we are almost on the same page. My situation is that I have been dealing in used books on the internet for almost 12 years and moving toys and household goods from retail clearance/end lot to the internet for about 2.5 years. So, I know I can make way more money (all expenses accounted), for real-life instance, buying all the last year Xmas Barbies from a hardware store that is going out of business than I could likely make spending the same amount of money on Mattel stock and I can make an even better ROI (but not so much CAGR because rare used books sell much slower than any Barbie) going to a university book sale which is generally a highly inefficient market where books with wildly varying values on the internet market are all priced something like $1 hardcover and 50 cents for paperback. But, obviously, it is way more work to trade on the discard market than to simply buy some stock and I would be very hard pressed to find $5000 worth of discard goods to trade this week, whereas I could readily purchase $5000 worth of stock in a minute.

Now, in my mind, there is sort of a continuum where finding chicken on sale for 79 cents a pound and finding Barbies on sale for 70% clearance is basically the same process or decision matrix. Doesn't make that much difference that I intend to consume the chicken myself and store it in the freezer vs. sell the Barbies and store them in the Amazon distribution system and making the second trade now provides the cash I need to make the first trade later. So, what I am trying to figure out is how to fit buying stock into this model if I can't get a good deal on buying stock because the stock market is efficient. Based on what GTOO wrote, I decided that maybe it's more like buying a tool or a machine that you intend to keep rather than consume or trade.

Anyways, my real problem is that I am too lazy to work more than I have to most of the time so I haven't really even had to confront the situation of having to buy/trade $5000 worth of discard goods in a week. However, it is my goal to ramp things up this year so I would like to know what to do in this eventuality.

[archi]

If you are buying something somewhere because you know you can sell it somewhere else for a margin (a price difference exist between the 2 places), what you are doing is a kind of arbitrage.

The efficient market hypothesis states that by doing this, price will increase at the buying point and decrease at the selling point, thus the agent doing the arbitrage will at the end help the prices to align in both points, making the "right" price appear. Arbitrage agents make the market efficient.

For the stock market, people use that hypothesis as an argument to state that in a world where information tend to travel very fast, with many agents doing arbitrage everywhere, it's quite difficult to find unknown opportunities and thus to "beat the market", which is an argument to invest in automated index trackers that replicate market behavior.

[7Wannabe5]

Okay, that makes sense.

[jacob]

The fact that you're hard pressed to find $5000 per week shows the size of the inefficiency you're correcting by "actively trading". It's likely smaller than that then.

The stock market is no different than barbie dolls or frozen chicken. It's exactly the same thing, except there are many more participants and the market is much more centralized.

The counter-argument to the EMH is that while people have access to the same information, they don't necessarily draw the same conclusions about that information---this should not really be surprising. Furthermore the counter-argument to random walks is that sometimes mass psychology creates trends. The latter is a recent subject of academic research, e.g. Kahneman and Tversky. I don't think anyone has won Nobel prizes on the former observation yet but certainly lots of money has been made. See Jack Schwager's Market Wizards books for more detail.

[KevinW]

@KevinW - I agree that the implication of EMH insofar risk is defined as historic price-variance is that the risk/reward ratio (Sharpe ratio) of all securities are identical. However, is the statistical definition of risk actually part of the EMH? I mean, where does that assumption (that risk = variation of historical prices) come from? Is that part of "canonical EMH" or is that an extra assumption of modern(*) portfolio theory?

Honestly I am not certain of the history of this.

My sense is that EMH is stated qualitatively; I tried to use the non-numerate terminology "risk-reward proposition." There "risk" and "reward" incorporate anything that any market participant cares about, including both tangible fundamentals, and also intangibles like how cool or politically correct a stock is, or regime risk in the stock exchange. Academics and Wall Street like to focus on Sharpe ratios because they are a convenient mathematically and probably do model risk tolerance reasonably well for most people. But the EMH is more general than that. (That's my sense.)

Also, it would mean that it would be impossible to EXPECT to profit. Any profit would be explained by luck (the variation).

Well, it would mean it would be impossible to expect alpha. Stock trading is a zero sum game with respect to alpha. But stocks and bonds are growth assets. The MPT rationalization is that all stocks are subject to beta risk and beta risk is rewarded.

Put differently, mutual exchange works (creates wealth) so in the main, conducting commerce turns a profit. Due to the time value of money, businesses are willing to compensate investors for loaning capital so that they can conduct commerce. This is a key difference between securities, and commodities (Barbie dolls, chicken, gold). A basket of arbitrary securities can be expected to earn a positive real return (not necessarily large, but positive) whereas a basket of commodities cannot.

[7Wannabe5]

Jacob said: The fact that you're hard pressed to find $5000 per week shows the size of the inefficiency you're correcting by "actively trading". It's likely smaller than that then.

True. However, there are many different markets and many different goods to move between markets. Once you get into the mindset of being a universal trader or scavenger, you become subject to an almost infinite regress of work you could be doing. Like I could be trading stocks on my smart phone as I save money by walking to the supermarket for discount chicken along a path I charted to include stopping at yard sales to scout for items to trade at a local consignment store and books to trade on Amazon and picking crab apples from tree in public park to make jelly to barter with my neighbor for help fixing my printer while I am being paid $5/hour for pushing a baby in a stroller. Etc. etc. etc.

The counter-argument to the EMH is that while people have access to the same information, they don't necessarily draw the same conclusions about that information---this should not really be surprising.

True. Like not everybody would conclude that it is better to buy discontinued pink giraffe crib sheets rather than discontinued pink giraffe crib bumpers if they are both 90% off retail because not everybody would remember in that decision moment how much more likely it is that a baby will ruin a sheet rendering that item the one that must be replaced if you want to keep your nursery matchy-matchy.

Kevin W said: Put differently, mutual exchange works (creates wealth) so in the main, conducting commerce turns a profit. Due to the time value of money, businesses are willing to compensate investors for loaning capital so that they can conduct commerce. This is a key difference between securities, and commodities (Barbie dolls, chicken, gold). A basket of arbitrary securities can be expected to earn a positive real return (not necessarily large, but positive) whereas a basket of commodities cannot.

Unless your basket holds all of that commodity. One of the umpteen books I am reading right now is "The Prize: The Epic Quest for Oil, Money and Power." The conclusion I am drawing from the information in this book is that if I really want to pile up some money I should model my behavior after that of John D. Rockefeller and try to achieve complete dominance over the market for some commodity by any means possible. Like I could buy every 1979 Skipper doll I could get my hands on and then set my price. I think it would be somewhat evil to do this with oil or books but I don't have any empathy for doll collectors (though maybe this would be taking advantage of people with poor mental health...)

Anyways, my DH has $40,000 in an IRA that he doesn't really need so he has given the management of it over to me. I agreed because I want to start learning about what I should do in the eventuality that I pile up some money (as opposed to rare books.) So, I was reading "The Bogleheads' Guide to Investment" (because it was the first recommended book on the topic that became available on my public library request list) and that's why I started fretting about the EMH. It did seem a bit like a commercial for investing in an index fund and your advice confirms that. I might also note that my DH strongly implied that he will give me some money if I really do well managing his IRA but he won't penalize me if I fail. Therefore, any advice you could offer on high variance investments would be appreciated.

[Chad]

Here are some of the people taking advantage of the inefficient market.

http://t.ritholtz.com/bigpicture/#!/ent ... 6ccf3874/1

Soros and Dalio are in a completely other league. The interesting thing is almost no one has heard of Dalio.

[7Wannabe5]

Thanks. I downloaded a free copy of "Principles" by Dalio. It seems much more interesting than the Boglehead book.

[Dragline]

If you are curious, here's the history of EMH from the guy who coined the term:

http://www.youtube.com/watch?v=NUkkRdEknjI

To see where it came from, watch the last two minutes. It's 50% marketing hype!