Nov 27 JDN 2459911
The efficient market hypothesis is often stated in several different ways, and these are often treated as equivalent. There are at least three very different definitions of it that people seem to use interchangeably:
- Market prices are optimal and efficient.
- Market prices aggregate and reflect all publicly-available relevant information.
- Market prices are difficult or impossible to predict.
The first reading, I will call the efficiency hypothesis, because, well, it is what we would expect a phrase like “efficient market hypothesis” to mean. The ordinary meaning of those words would imply that we are asserting that market prices are in some way optimal or near-optimal, that markets get prices “right” in some sense at least the vast majority of the time.
The second reading I’ll call the information hypothesis; it implies that market prices are an information aggregation mechanism which automatically incorporates all publicly-available information. This already seems quite different from efficiency, but it seems at least tangentially related, since information aggregation could be one useful function that markets serve.
The third reading I will call the unpredictability hypothesis; it says simply that market prices are very difficult to predict, and so you can’t reasonably expect to make money by anticipating market price changes far in advance of everyone else. But as I’ll get to in more detail shortly, that doesn’t have the slightest thing to do with efficiency.
The empirical data in favor of the unpredictability hypothesis is quite overwhelming. It’s exceedingly hard to beat the market, and for most people, most of the time, the smartest way to invest is just to buy a diversified portfolio and let it sit.
The empirical data in favor of the information hypothesis is mixed, but it’s at least plausible; most prices do seem to respond to public announcements of information in ways we would expect, and prediction markets can be surprisingly accurate at forecasting the future.
The empirical data in favor of the efficiency hypothesis, on the other hand, is basically nonexistent. On the one hand this is a difficult hypothesis to test directly, since it isn’t clear what sort of benchmark we should be comparing against—so it risks being not even wrong. But if you consider basically any plausible standard one could try to set for how an efficient market would run, our actual financial markets in no way resemble it. They are erratic, jumping up and down for stupid reasons or no reason at all. They are prone to bubbles, wildly overvaluing worthless assets. They have collapsed governments and ruined millions of lives without cause. They have resulted in the highest-paying people in the world doing jobs that accomplish basically nothing of genuine value. They are, in short, a paradigmatic example of what inefficiency looks like.
Yet, we still have economists who insist that “the efficient market hypothesis” is a proven fact, because the unpredictability hypothesis is clearly correct.
I do not think this is an accident. It’s not a mistake, or an awkwardly-chosen technical term that people are misinterpreting.
This is a motte and bailey doctrine.
Motte-and-bailey was a strategy in medieval warfare. Defending an entire region is very difficult, so instead what was often done was constructing a small, highly defensible fortification—the motte—while accepting that the land surrounding it—the bailey—would not be well-defended. Most of the time, the people stayed on the bailey, where the land was fertile and it was relatively pleasant to live. But should they be attacked, they could retreat to the motte and defend themselves until the danger was defeated.
A motte-and-bailey doctrine is an analogous strategy used in argumentation. You use the same words for two different versions of an idea: The motte is a narrow, defensible core of your idea that you can provide strong evidence for, but it isn’t very strong and may not even be interesting or controversial. The bailey is a broad, expansive version of your idea that is interesting and controversial and leads to lots of significant conclusions, but can’t be well-supported by evidence.
The bailey is the efficiency hypothesis: That market prices are optimal and we are fools to try to intervene or even regulate them because the almighty Invisible Hand is superior to us.
The motte is the unpredictability hypothesis: Market prices are very hard to predict, and most people who try to make money by beating the market fail.
By referring to both of these very different ideas as “the efficient market hypothesis”, economists can act as if they are defending the bailey, and prescribe policies that deregulate financial markets on the grounds that they are so optimal and efficient; but then when pressed for evidence to support their beliefs, they can pivot to the motte, and merely show that markets are unpredictable. As long as people don’t catch on and recognize that these are two very different meanings of “the efficient market hypothesis”, then they can use the evidence for unpredictability to support their goal of deregulation.
Yet when you look closely at this argument, it collapses. Unpredictability is not evidence of efficiency; if anything, it’s the opposite. Since the world doesn’t really change on a minute-by-minute basis, an efficient system should actually be relatively predictable in the short term. If prices reflected the real value of companies, they would change only very gradually, as the fortunes of the company change as a result of real-world events. An earthquake or a discovery of a new mine would change stock prices in relevant industries; but most of the time, they’d be basically flat. The occurrence of minute-by-minute or even second-by-second changes in prices basically proves that we are not tracking any genuine changes in value.
Roulette wheels are extremely unpredictable by design—by law, even—and yet no one would accuse them of being an efficient way of allocating resources. If you bet on roulette wheels and try to beat the house, you will almost surely fail, just as you would if you try to beat the stock market—and dare I say, for much the same reasons?
So if we’re going to insist that “efficiency” just means unpredictability, rather than actual, you know, efficiency, then we should all speak of the Efficient Roulette Hypothesis. Anything we can’t predict is now automatically “efficient” and should therefore be left unregulated.