Impossibly Efficient

Every undergraduate student of finance learns to recite the three levels of the Efficient Market Hypothesis (EMH). Few of those will be able to tell you about the most compelling and elegant critique of that hypothesis. EMH should only be taught if the teacher immediately presents the arguments from “On the Impossibility of Informationally Efficient Markets” by Grossman and Stiglitz (1980).

EMH posits that information relevant to the value of a stock is immediately discounted into its price. So the only way to make abnormal returns on a consistent basis would be to trade on information that has not been publicly disseminated. Rightly, doing so is illegal since it undermines the capital allocation process. Therefore, unless you have an incarceration wish you should not bother trying to figure out which stocks are worth buying and selling and instead invest passively. But the EMH does not deal with how the information makes its way into prices, nor does it consider that there are degrees of uncertainty in almost every piece of information relevant to financial markets. Both points mean that the most prepared, diligent and hard-working of analysts and fund managers can make outsized returns, contrary to the EMH.

Grossman and Stiglitz point out that if everyone invested passively there would be no one figuring out what the information means. In that case there is an incentive for one person to defect and independently estimate the value of a stock. Since one person can only have a modest impact, the argument extends until there is a large number of people processing and analysing what is relevant.

The interesting quirk is that by dismissing the EMH, investors are making prices more efficient and making it harder for each investor to earn outsized returns. So the stable equilibrium is one in which a critical mass of analysts are figuring out what the information means and those not doing so are better off piggy-backing on that and investing passively.

Individual analysts are often wrong, but as a group they are reasonably good at figuring out the potential impact of a piece of information. What they do is essential to the markets efforts to zero in on a fair cost of equity for the large number of companies in existence. That they disagree, their conclusions suffer from a multitude of biases and they are bound by a range of constraints, reflects the uncertainty inherent in the information that the EMH takes as unequivocal.

The EMH is useful only in highlighting that the world works in a different way. Those teaching the hypothesis should spend more time explaining how to price risk and less time giving the impression that it prices itself.


2 thoughts on “Impossibly Efficient

  1. Anyway, the best arguments against EMH are Shiller (1984) “Unpredictability is a necessary but not sufficient condition for market prices to be rational” and Shleifer and Vishny (1997) “limits of arbitrage”

  2. EMH is a limiting principle that is never reached. The markets vary in their information efficiency over days, months and years. Strategies are forgotten and remembered as rents wane & wax, respectively, with momentum leading to overshoots that keep the system volatilie, and honest (after a fashion).


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