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What if we all Know Less Than we Think?

Do you think you’re a better than average driver?  Or a better than average lover?  Or a better than average trader?   Odds are, you do.  Unfortunately, we can’t all be better than average drivers, lovers or traders.  This illusion of superiority is a common cognitive bias in most things.   So what happens when we construct economic models designed around the idea that the entire economy is “rational” or even understands the information that goes into the pricing of securities, assets or even goods and services?  Well, you get things like the Efficient Market Hypothesis.

I was reading a well known paper by William Sharpe on this topic.  He describes the theory as follows:

“The key idea behind the theory is that of market efficiency.

Definition is difficult, but the idea is that a market is efficient if there are many very bright, well informed analysts constantly searching for securities that are mispriced.  As long as this force is operative, when information becomes reasonably public, it will lead to transactions that will shortly cause prices to reflect the information appropriately.  As a result, the price of a security will rarely diverge significantly for long from its intrinsic value where the latter is defined as the certain present value of the uncertain future prospects assessed by a clever, well informed analyst.”

You’ll notice a number of gigantic assumptions in this definition.  Not only does the theory assume that market participants are “bright” (ie, they understand money, the monetary system, the financial system, complex dynamical systems, etc), but it assumes that they also understand what “value” is in the first place.   But what if we don’t understand our financial system all that well?  And what if “value” is a nebulous idea much like the idea of “beauty”?  That would seem to be a rather substantial wrinkle in the ideas that underlie the Efficient Market Hypothesis and foundational economic concepts like rational expectations…..

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