Proponents of the Efficient Market Hypothesis are masters at marketing their concepts by simplifying them into easily discernible ideas. For instance, I ran across this post by Tim Harford who writes for the FT in which he discussed how the grocery store makes for a good EMH analogy. The story goes like this – you finish getting your groceries only to begin eyeing the checkout lines. Which one do you choose? Grocery store checkout lines are a great example of an efficient market, right? They’re simple, we all have the same information and one would assume, that, on average, it’s extremely hard to consistently choose the best line because of the “wisdom of crowds”. That is, everyone else is working with the same set of information and digests it in a manner that doesn’t make it possible or worthwhile to try to pick the best line. It’s so obvious and easy to understand, right?
Tim goes further though. He says:
“All this assumes something rather important: that the risk-adjusted return (or the length of the queues) is indeed the same.”
I’m an American critiquing an English author’s article so I just have to say, “bollocks!” The thing is, we all know what “risk” is in the grocery store. The risk in the grocery store line is that you’ll waste time relative to another line. That’s it. It’s not hard to understand and everyone who confronts the grocery store checkout line knows precisely what they’re trying to avoid, how to quantify it and how to try to avoid it. But the financial markets are totally different for several reasons:
- We all have different perceptions of what “risk” is.
- Most of us actually have no idea what market “risk” means in the first place.
- None of us actually knows what the risk of assets relative to others is at any given time (although I’d argue that some people come much closer than others).
This presents a very different situation than the simple and easily discernible grocery store analogy. Now, the EMH is based on rational expectations and the idea that markets are in equilibrium. And based on this (total misrepresentation of reality) the idea goes that the risk adjusted returns of all investments should be roughly equivalent because the market will price assets according to their proper risks. But there’s that word “risk” again. The word that no one in financial markets really understands, can quantify or knows the relative value of. Yes, academic economists like to use standard deviation because it’s easy to quantify, but volatility is hardly the only way one perceives financial risk. In fact, volatility could be a very good thing. In reality, the idea of “risk” is dynamic, evolving and uniquely personal. But the academic models presenting this idea turn it into a static and quantifiable concept which misrepresents reality.
This presents us with a different conundrum though. If no one really understands the risks they’re undertaking when they put money to work in the markets then how are the assets being priced efficiently so that good risk adjusted returns are hard to come by? One would assume the assets aren’t actually being priced “right” or efficiently. Instead, they’re being priced wrong. But that doesn’t make the market easy to predict. After all, this misunderstanding actually means that markets are hard to predict because everyone is working with such an imprecise and different set of understandings that one must also be able to predict when and how those participants are mispricing assets (in addition to assuming that those same irrational participants will one day price the assets the way YOU think they should).
The key point is, none of this has anything to do with rational expectations, equilibrium and the all knowing market. In fact, it’s precisely the opposite. It’s the stupidity of the crowd that often makes it so difficult to make money in the markets. And so none of this should rationalize the underlying ideas in the Efficient Market Hypothesis. And sadly, easily discernible analogies only muddy the waters rather than help to clear them up.