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The efficient market (non-)paradox

The efficient market (non-)paradox
October 25, 2013
The efficient market (non-)paradox

This argument - which dates back to a 1980 paper by Joe Stiglitz and Sanford Grossman - is as follows. If markets were informationally efficient, nobody would have any incentive to analyse corporate information, because by definition doing so wouldn't yield any return. But if nobody looked at such information, it would never get into share prices, and so markets would be inefficient. If rational people believed markets were efficient, therefore, they wouldn't be efficient. Efficiency requires that investors are irrational - that they go to the bother of analysing information, even though it is pointless to do so. But this contradicts the assumption behind the efficient market hypothesis, that investors are rational.

However, I'm not sure this argument has much practical relevance, simply because it's easy to believe that, in the real world, people are sufficiently (moderately) irrational to chase information even though it is futile to do so.

One cognitive bias that might cause them to do this is simply overconfidence. If you believe you can spot things that others can't, you will scour company accounts for information.

And once you believe this, a mixture of Bayesian conservatism and self-serving biases can bolster it. Having convinced yourself that it's worth analysing information, it's easy to stay convinced simply because the feedback you get is so noisy. Say, for example, you invest in small or value stocks and do well. You'll find it easy to think this is because you have beaten an inefficient market. But it might instead be because - as Professor Fama has argued - such stocks are riskier than others, in part because they carry more cyclical risk. How can we tell which view is right? We can't - unless we know how much return is appropriate for such risks. And this is arguable.

What's more, even if these extra risks materialise - as they did in 2008-09 - you can blame bad luck rather than efficient markets.

In this way, beliefs in inefficient markets can persist. This is especially true of professional investors. As Upton Sinclair famously said: "It is difficult to get a man to understand something, when his salary depends on his not understanding it".”

Nor is it the case that such beliefs will disappear from the market as their holders lose money and exit. As Bjorn-Christopher Witte of the University of Bamberg and INSEAD's Bernard Dumas have shown, the smart money doesn't necessarily drive out the stupid.

In this sense, cognitive biases research, far from undermining the key message of efficient market theory, can actually help buttress it.

You might ask here: if people are irrational about their motives for picking stocks, won't they also be irrational about how they do so, in which case the market will be inefficient?

Not necessarily. There are different levels of rationality. It is entirely possible to have an irrational project, but pursue it intelligently. This is perhaps true of any obsessive. There's a stock figure in fiction of the mad scientist - from Dr Frankenstein to Walter White - who does just this.

You might object here that introducing irrationality to save the efficient market hypothesis from the Grossman-Stiglitz paradox violates the spirit of the hypothesis which is predicated upon rationality.

True, but irrelevant. What matters about a theory is not whether it is logical or ideologically sound but simply whether it fits the facts.

By all means, produce empirical evidence that markets are inefficient; I suspect the momentum anomaly is stronger evidence here than the success of men such as Neil Woodford or Warren Buffett, who have performed unreplicable experiments. But don't dismiss the efficient market hypothesis as contradictory. That's just lazy armchair hand-waving.