Why the “efficient market theory” is bullshit ?

The efficient market theory, which states that the stock market moves randomly (because all the available information about the stocks are already factored in the price, and future movements depend solely on random future events that are not known yet), has a very strong following among “ivory tower economists”, even though it has been proved wrong experimentally. Here I want to argue why this theory is fundamentally, theoretically wrong.

For the efficient market theory to work, some utopic  hypotheses must hold:

1 – Information is “symmetric” (every information about a stock is available at the same time to all market players, and not just to a group of players)

2 – People can determine the “fair expected value” of a stock based on available information, and all people arrive at the same expected value.

3 – People behave rationally, i.e. they buy when the stock is under fair value and sell when the stock is above fair value, and not the other way around.

4 – All actions take place immediately (e.g. if the value changes then the price also changes  instantanously to match the value)

Why the above assumptions are utopic (even more utopic than the so called scientific communism) ?

1 – Information is not symmetric in general. The insiders and those who have access to the insiders always know more than the average Joe.

There are people who even buy stocks without knowing what stocks they are buying. When they hear that “stocks are going up”, they just go to the brokerages and say “give me some stocks !”. This is not a joke. Maybe it doesn’t happen often in the US, because people there are more or less educated about the stock market, but it happens quite often in emerging markets like Vietnam.

2 – Even assuming that everybody knows everything, then different people still arrive at different conclusions.

Ask 10 analysts about the fair value of a stock, and you will get 10 different answers. In fact, it is almost never possible to calculate the exact fair price of a stock. The most one can do is to arrive at a range of poissible values, together with some kind of probability distribution. But everybody has his/her distribution which is different from the others’

3 – People behave “rationally”, but  in the sense of “greater fool theory”, not in the sense of efficient market theory. Even if they think that something is overvalued, they will still buy if if they think that the price will continue to move up short-term and they will find some fool who will buy back from them at a greater price.

Otherwise how would one explain the tulipe mania (Netherlands, some centuries ago) ? Or a current example: even though the shares of the old General Motors (now bankrupt) are fundamentally worthless (the government made it very clear that the company will be completely liquidated and the shares will vanish — there will be a new GM, but the old shares don’t give access to any shares of the new GM), people are still trading them today (at around 50-100 cents/share) ! Some people buy them because they don’t know that the shares will go to zero. Other people are buying and selling them, even when they know that the shares will go to zero, but they still buy as long as there are some other guys ready to pay a higher price for those worthless shares !

4 – Things always take time to play out.

Rome was not built in a day. In 1944 it was very clear that the nazi Germany was kaput, but it took another year for them to surrender. Similarly in the stock market. When there is a force, it will affect the stock prices gradually over a period of time, not just once instantanously.

In mechanics and physics, the differential equations that describe the dynamical systems (the movement of everything in the universe) are usually of second order, and the phase space has double the dimension of the configuration space: the state of something consists of its position (in the configuration space) and its velocity (or momentum). It’s the law of nature: the forces change the velocity, and the velocity changes the position. Those efficient market theorists must have zero knowledge of physics, because they think that the forces change the position directly, without velocity. They ignore half of the dimension of the system. This is the main point why their efficient market theory is complete bullshit !

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3 comments to Why the “efficient market theory” is bullshit ?

  • I completely agree. I started like an entire blog ranting about a lot of the issues that I have with efficient market hypothesis. It is a matter of philosophical purpose. If EMH IS true than we cannot and will not be able to continue to exist as a profession.

  • econometrics MonsterID Icon econometrics

    just run a SACF plot on any stock market time series of percentage returns squared and it is clear that the series exhibits a high level of persistence in the autocorrelations (i.e. the variance exhibits patterns). moreover if you run the SACF on the non-squared values, you see that they are NOT entirely white noise as the EMH would suggest. While the persistence is much lower on the levels (i.e. the mean), it does exist and can be exploited to predict the time series.

  • admin MonsterID Icon admin

    Thank you, Micheal Corley and econometrics, for interesting comments

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