I think that when when I look at economics (another great example) you have a series of papers by Larry Summers and Brad DeLong in the early 90s that as far as I can tell drive a stake through the heart of the idea of efficient markets. They show that if you make the extremely minimal assumption of people not being perfectly capable of assessing how much risk is involved in an investment, there should be a systematic tendency for markets to become less efficient with time.
And as far as I can tell this behavior—this paper despite being done by pretty much the top people in economics—just got ignored and had no impact on the—or this series of papers—had no impact on the progression of the field. It was logically ironclad. That’s the sort of thing I basically expect from most sciences in the modern world—almost everything but applied physics—and it’s (you know) this is a particularly clear case though because you have essentially the strongest possible argument done by the most prestigious possible people with just no recollection of it ever having happened in the profession.
Does anybody know what papers he’s talking about? (I’m not sure if I transcribed the names properly.) They seem very relevant to this discussion.
″ The unpredictability of noise traders’ beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do.”
(This paper has been quoted 6831 times according to Google Scholar).
I upvoted for relevance (although it’s not quite what I asked for). Interesting read.
The efficient-market hypothesis is coherent, falsifiable and wrong, even in its weakest form: The paper describes a way to introduce an inefficiency, that were it arbitraged optimally, would solve an (NP-complete) satisfiability problem. Even if P = NP (which seems unlikely), it remains unproven, so nobody yet knows how to solve NP-complete problems in PTIME, which would be required for markets to be truly efficient.
The eldritch abomination may grow stronger with every attack, but it is decaying even faster than we can fight it. The number of possibilities to search for anomalies grows faster than our ability to compute them when you account for the possibility of anomalies in the pricing of sets of securities, like for pairs trading. There might be something like 100,000 publicly-traded stocks in the world, but that would mean (1000002) combinations or nearly five billion pairs. And that’s not even considering larger subsets, like triples, which would be on the order of hundreds of trillions.
So the EMH can’t be literally true. but can it be approximately true? It must be to some degree for the question to be this contentious. The real question I’m interested in, is “Are the markets exploitable?” Is there such a thing as alpha, or its it just luck? If finding exploits is as expensive as exploiting them is profitable, then the EMH might as well be true for that purpose. But if there are plenty of anomalies to go around, then I could have a realistic chance of finding and profiting from one nobody has noticed before.
I stumbled across a comment about efficient markets in an old Michael Vassar interview
Does anybody know what papers he’s talking about? (I’m not sure if I transcribed the names properly.) They seem very relevant to this discussion.
He could be referring to:
De Long, J. B., Shleifer, A., Summers, L. H., & Waldmann, R. J. (1990). Noise trader risk in financial markets. Journal of political Economy, 98(4), 703-738. Retrieved from http://www.nccr-finrisk.uzh.ch/media/pdf/DeLongShleiferSummersWaldmann_JPE1990.pdf
From the abstract:
″ The unpredictability of noise traders’ beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do.”
(This paper has been quoted 6831 times according to Google Scholar).
A different paper but in the same vein: Markets are efficient if and only if P= NP
I upvoted for relevance (although it’s not quite what I asked for). Interesting read.
The efficient-market hypothesis is coherent, falsifiable and wrong, even in its weakest form: The paper describes a way to introduce an inefficiency, that were it arbitraged optimally, would solve an (NP-complete) satisfiability problem. Even if P = NP (which seems unlikely), it remains unproven, so nobody yet knows how to solve NP-complete problems in PTIME, which would be required for markets to be truly efficient.
The eldritch abomination may grow stronger with every attack, but it is decaying even faster than we can fight it. The number of possibilities to search for anomalies grows faster than our ability to compute them when you account for the possibility of anomalies in the pricing of sets of securities, like for pairs trading. There might be something like 100,000 publicly-traded stocks in the world, but that would mean (1000002) combinations or nearly five billion pairs. And that’s not even considering larger subsets, like triples, which would be on the order of hundreds of trillions.
So the EMH can’t be literally true. but can it be approximately true? It must be to some degree for the question to be this contentious. The real question I’m interested in, is “Are the markets exploitable?” Is there such a thing as alpha, or its it just luck? If finding exploits is as expensive as exploiting them is profitable, then the EMH might as well be true for that purpose. But if there are plenty of anomalies to go around, then I could have a realistic chance of finding and profiting from one nobody has noticed before.
I think The Economic Consequences of Noise Traders is one of those papers.