Markets are efficient if and only if P = NP

by confluence • 14 years ago

107 123 14 years ago

Bakkot• 14 years ago

Of course this doesn't mean markets aren't within some small constant factor of being perfectly efficient.

confluence18• 14 years ago

Generally with NP-complete problems - that small constant factor is still often an order of magnitude away from optimal (path finding/search/salesman/shortest subsequence etc).

sold• 14 years ago

In general, approximation of NP-complete problems is not that simple. Assuming P /= NP,

Subset-sum can be approximated within 1+epsilon for any requested epsilon>0 [a PTAS]

MAX-3SAT can be approximated within 8/7 and not better. Vertex cover can be aproximated within 2 and its not known if that's optimal.

Set cover can be approximated within O(log n) and not better.

Clique and TSP have no sensible approximation.

I would argue that potentially a loss of factor 2 is not an order of magnitude away from optimal. I don't know what is the situation for markets.

Dn_Ab7• 14 years ago

Computational Complexity is about asymptotics so constant factors are irrelevant. In this case if perfects markets require numbers of operations that grow astronomically with respect to input and P <> NP then the best we could do are hueristics and approximations. Indeed it is possible (I think likely) that in many cases even getting good approximations will be in NP.

Also worth noting is that the expensive nature of being perfectly informed is one of the main drivers of the large sizes of firms. We can measure how well markets are doing with respect to the amount of excess, beyond normal profit that producers can capture in the long term. Current polarization of wealth and excess of rent suggest no, we are very far from efficient markets.

There is an argument one can give that the abstraction of interacting humans leads to a computer more powerful than a regular turing machine. I don't believe this but everyone who thinks AI is not possible on a turing machine does.

confluence18• 14 years ago

A slightly long and/or dodgy video by the professor who wrote this (I'm setting your expectations): http://www.youtube.com/watch?v=7iOJZZFDKpc

I found it rather enlightening - but the paper is still highly readable and I encourage HNers to peruse it and perhaps check out the video as well.

Previous discussions:

http://news.ycombinator.com/item?id=2895474

http://news.ycombinator.com/item?id=1144548

More from the professor: http://philipmaymin.com/cv.pdf?q=phil/cv.pdf

brador• 14 years ago

Direct link: http://arxiv.org/pdf/1002.2284v2 [PDF]

kenster07• 14 years ago

Economics is clear when explaining its foundation: Markets are only as efficient as its participants are rational and fully informed. The entirety of modern economics is built upon the presumption that the last two conditions are 100% true.

Dn_Ab7• 14 years ago

True, there is a lot to be learned from behavioural economics. But neoclassiscal stuff is not all bad. The notion of bounded rationality which places limits on the rationality of people is kind of old. And in aggregrate; people, corporations in particular do tend to approximate rationality. This is why they can be 'psychopathic'.

aristidb• 14 years ago

No, it's based on them being true enough that other approximations are less useful models.

wisty2• 14 years ago

Unfortunately, most economists don't develop other models, so the other models are very immature.

batista8• 14 years ago

>No, it's based on them being true enough that other approximations are less useful models.

That is, in wishful thinking.

No other field has a worse prediction track record that economics.

Jabbles• 14 years ago

Bollocks. Abstract economic theories may be based on these assumptions but the majority of economists make a living on the fact that the market is not efficient.

batista8• 14 years ago

>but the majority of economists make a living on the fact that the market is not efficient.

Actually they make a killing on the fact that their are interests and money to be made based on their BS advice and predictions.

batista8• 14 years ago

>Economics is clear when explaining its foundation: Markets are only as efficient as its participants are rational and fully informed.

Plus even more assumptions: that participants cannot game the system (by influencing laws, abusing power or monopoly, bribing others participants, controlling public opinion by friendly or owned mass media, forming cartels, etc).

Oh, and "rational" doesn't just mean "clearly thinking and clever", but also perfect calculating actors in a game-theoretic way.

Oh, and there are no factors outside of direct market control, from natural disasters and resources, to foreign country policies and such.

So all those hold even remotely true only in some magic unicorn land.

tatsuke9513• 14 years ago

Meanwhile, an enterprise with hundreds of trained economists (read: The Fed) used this magical unicorn training and prevented the Great Recesession from becoming the Great Depression II. All using economic theory. And if it wasn't for political interference/inaction, we'd be even further ahead, thanks to them.

I know people hate to hear that, and it's en vogue to rip on the field of economics, but it's true.

yummyfajitas7• 14 years ago

You really need to go learn some economics.

All of the topics you mention are popular topics of study. For example, gaming the system by influencing laws was studied by (picking a famous name here) Hayek. Monopolies/monopsonies are well studied and generally believed to be inefficient.

Information asymmetries and actors with bounded rationality are extremely popular topics to study today.

The paper we are discussing here is a perfect example describing the microfoundations of bounded rationality, for example.

pmb• 14 years ago

But "rational" and "fully informed" isn't enough. If I encode prices as a 3SAT problem, then your "rational" and "fully informed" person will be required to solve a (thought-to-be) too hard problem in order to do the efficient thing.

Therefore, either you can solve such a problem efficiently (and P=NP) or the idea that all you need is rationality and information is false.

pron7• 14 years ago

I have only had time to skim through this very quickly, but it seems entirely based on false definitions.

He begins so:

The efficient market hypothesis claims that all information relevant to future prices is immediately reflected in the current prices of assets. In other words, you cannot consistently make money using publicly available information.

Then, he encodes a 3-SAT problem into market orders and claims:

So what should the market do? If it is truly efficient, and there exists some way to execute all of those separate OCO orders in such a way that an overall profit is guaranteed ... then the market, by its assumed efficiency, ought to be able to find a way to do so.

So he defines market efficiency to be all-knowing, and then gives at an NP-hard problem to solve. It seems like he could have given it the halting problem as well, only it might be harder to encode as market orders. But the point is that an efficient market is "all knowing" only that which is "knowable". The market isn't an oracle that can answer any question about the past, but a true machine that can answer all questions about the past that are answerable using the machine.

What he's doing seems similar to saying "if God exists then P=NP". After all, if God is omniscient and omnipotent, He could solve all NP problems in polynomial time. :)

ubernostrum• 14 years ago

I think this demonstrates, in a clever way, the types of absurdities that result from assumptions economists make about markets and the people who act in them :)

uvdiv• 14 years ago

I skimmed it quickly too, but I think you've misread. The "interesting" claim isn't the 3-SAT encoding; it's earlier where he claims that markets "naturally" have to solve NP-hard problems, in particular that to optimize an investment strategy you have to solve the Knapsack problem. (?!) It's hand-waving nonsense.

pron7• 14 years ago

It doesn't matter. When people say efficient market, they mean that the market knows whatever is knowable by the present time using current technologies. They don't mean that the market knows everything that's theoretically knowable using unknown/impossible algorithms.

Before there were computers in an efficient market (supposing one exists), the current prices would reflect everything that is known and can be computed/deduced without computers by the present time.

Anyway, the paper misunderstands "known" to mean "anything which can theoretically be known", which obviously includes solutions NP-hard problems. It's just that nobody claims that's what efficient markets are.

Dn_Ab7• 14 years ago

I'm surprised he decided to use 3-SAT instead of pointing out the non-convexities which arise in optimization for many interesting markets. Or the problem with digital goods say. That these are exploitable is what leads to excess returns and monopolies. These are failings due to reasons one can argue with computational compexity (non convex optimization is in NP).

aurelianito• 14 years ago

'If God exists then P=NP. After all, if God is omniscient and omnipotent, He could solve all NP problems in polynomial time. :)'

Great quote! I will take it.

gizmo6862• 14 years ago

But it is not entierly true. P=NP means that the set of problems that can be solved in polynomial time on a turing machine is the same set as could be solved on a non-deterministic turing machine. Assuming God exists, I think it would be safe to say that he is capable of using atleast a non-deterministic turing machine, so his ability has no bearing on P=NP.

Similarly, it is possible (theoretically at least) that the market has access to some means of computation not available to a turing machine. Given that most of the market is run by traditional, turing, computers, that does not seem to be the case.

Evbn• 14 years ago

Omniscience and omnipotence don't say anything about algorithmic runtime.

lobo_tuerto• 14 years ago

If you are omniscient and omnipotent then there is no runtime.

stevenrace• 14 years ago

Previous discussions [Aug. 2011]:

- http://news.ycombinator.com/item?id=2895474

- http://news.ycombinator.com/item?id=2868498

anonymouz2• 14 years ago

Is this a serious paper? I can't judge at all if it is, because I cannot find any useful definitions, exact statement of the claimed theorem or proofs.

Then again, I'm not an economist (coming from a mathematics backround), so maybe this is the expected form of a paper here?

yummyfajitas7• 14 years ago

The original papers proving similar results do prove theorems. This is one example which springs to mind:

http://dpennock.com/papers/chen-ec-2007-betting-on-permutati...

Here is a review of the literature from a while back, it cites plenty of actual math papers:

http://dpennock.com/papers/pennock-ijcai-workshop-2001-np-ma...

realize• 14 years ago

The ability of some traders to make consistent significant profits should be an "existence proof" of the inefficiency of markets. The EMH is just wrong.

evolve2k• 14 years ago

The question is not 'can traders make a consistent profit' but rather 'can anyone make a profit using just publicly accessible historical data alone' this is the essence of EMH.

Most professional money managers make their gains by actively interviewing companies in a form a stylized intentional financial journalism if you will.

tatsuke9513• 14 years ago

Now you just need to point to some traders who are able to make "consistent significant profits".

rafcavallaro• 14 years ago

And not just "some" but a proportion of profitable traders greater than what we would expect due to chance - i.e. the existence of some lottery winners does not prove that playing the lottery is in general profitable.

meric6• 14 years ago

A while ago I studied a paper where the author proposes using high frequency trading to exploit price patterns. If that can be done profitably it would mean markets aren't even weak form efficient! Lately however there have been emerging views that "efficiency" is not black or white but a continuum. i.e The market will only be efficient enough such that the marginal cost of making the market more efficient is equal to the marginal benefit of doing so.

Anyway, I wonder if solutions to NP-complete problems can be approximated using a market.

EDIT: According to the paper, they can.

Dn_Ab7• 14 years ago

Great point. I am certain that NP-complete problems that can be efficiently approximated can be approximated by markets. No reason why you can't replace algorithms and expertes in your ensemble or regret minimization framework with humans.

justincormack• 14 years ago

"The market will only be efficient enough such that the marginal cost of making the market more efficient is equal to the marginal benefit of doing so."

Do we have a model of what markets are like under this type of model? It is not clear to me that prices are even close to what efficient ones might be under this situation (though they could be).

Also of course most of the missing markets are the contingent and future ones, which suggests the ways in which things might be biased (forward planning, the firm, the business cycle etc) which are quite important inefficiencies.

meric6• 14 years ago

  "Do we have a model of what markets are like under this 
  type of model? It is not clear to me that prices are even 
  close to what efficient ones might be under this situation 
  (though they could be)."

I don't know what markets are like under this type of model but here are a two papers recommended by my lecturer on how efficiency is not an either-or proposition.

Adaptive Markets and the New World Order

"Under the AMH, markets are not always efficient, but they are highly competitive and adaptive, and can vary in their degree of efficiency as the economic environment and investor population change over time."

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1977721&#...;

Efficient Markets II (by Fama who was the one who originally came up with the efficient market hypothesis describing the three forms of market efficiency)

"A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed the marginal costs (Jensen (1978))."

http://efinance.org.cn/cn/fm/Efficient%20markets%20II.pdf

  "Also of course most of the missing markets are the 
  contingent and future ones, which suggests the ways in 
  which things might be biased (forward planning, the firm, 
  the business cycle etc) which are quite important 
  inefficiencies."

You can often find sets of stock options' prices that you can arbitrage and make a profit, but only if there were no transaction costs. Information will only be taken into account of if the cost of the information (after taking into account all costs including opportunity costs and risk) is less than the benefit from exploiting that information. So, there are probably lots of information from the future that are missing in the market, which if properly exploited will provide a lot of benefit; but the costs of gathering that information is even greater, possibly requiring the use of a time machine.

My thinking: It could very well be that markets are only efficient only as far as everything else allows it to be; If investors are not able to evaluate information over more than one business cycle, (due to the cost of doing so, economical or psychological or otherwise), then so be it. The market will move its efficiency to match the environment and its participants.

pron7• 14 years ago

A market can compute in some time period only that which is computable in that time period. The only one that says otherwise is the author of this paper, who then uses this assumption to prove... nothing really.

confluence18• 14 years ago

Honestly - stuff like this reinforces a feeling I have had recently that the social sciences are nothing more than pseudoscience dressed up most of the time.

Economists have essentially no idea what is going on and neither do their financial compatriots and the EMH is by far the clearest example of this.

I'm trying to make it a personal rule that anything outside of the hard sciences (math/physics/chemistry/statistics etc) is bullshit to me until further notice.

I mean really - I do advanced math and statistics in moderately complex systems - AI/robotics - and I can barely wrap my head around them. I shake my head in disgust at those who apply platonic and unrealistic theories to the extremely complex system that is the world. Indeed, the surety they display in their theories amuses me, because to even think that one can reason about the entire world all at once is, in fact, hilarious.

throwaway64• 14 years ago

This kind of armchair criticism is not particularly enlightening, or productive. You can still make useful and largely correct predictions without understanding all of the dynamics in a system.

After all, all science amounts to an approximate model, even your vaunted "hard sciences".

confluence18• 14 years ago

I'm sorry but were you alive during the last couple hundred financial crises?

I mean if your entire field is dedicated to predicting the future of finance and economics and you don't predict them - it kind of shows that you really don't know what you are doing.

All I'm doing is pointing out that the social sciences have no clothes on.

PeterWhittaker• 14 years ago

Not this. Unless we have explicitly and fairly advanced education, and are disciplined enough to apply it to all we do, we - the human species, every single one of us - suck at statistics, are terrible at understanding or predicting the behaviour of complex systems.

Read Kahneman's "Thinking,Fast and Slow" to get a better idea as to why.

Our biological heritage has left us - oh, OK, the vast majority of us - fundamentally incapable of understanding complex systems and making predictions that have any value beyond the immediate short term. Our intuition - our System 1 heuristics (read the book) - is completely ill-suited to this, and our reason - System 2 (ditto) - doesn't fare much better without advanced training.

Kahneman and others also cite many cases where trained experts make the same errors of judgement and analysis as the rest of us when they stray even fractionally from their areas of expertise.

The GP is right: We get a lot more of this "soft stuff" wrong than we get right because we generally don't bother to apply hard science methods to the problem.

Personal anecdote: I stopped listening to the news because I used to work in crypto. Well, that's the tl;dr reason.

I worked for a company that did PKI and noticed that tech journalists, who might be expected to at least have some greater technical background than just folk made egregious errors in their reporting, in reports that were researched and drafted and edited and considered and fact-checked prior to publication.

While PKI is complicated, it is not complex. Not like the economy. So if these "specialized" journalists with a technical leg up could get so much of something so simple so wrong, what were folks with degrees in English and/or journalism doing to something as advanced and out of our grasps as the economy?

Truth be told, I haven't stopped reading the news - I read it differently. Should an interesting headline catch my eye, I look for a few more. The more interesting the story, the more sources I check/read before accepting to learn anything from the reporting. This is a necessary side effect of how complex the world and its news are, and how simplistic reporting is.

Economists had no idea why their theories of rational actors were so flawed (but flawed they knew them to be) until Kahneman and Tversky came along. Hard science can only cast light on the dismal and dark, and the dismal and dark will remain so, will remain largely speculative, until they adopt our tools.

makomk• 14 years ago

To put it bluntly, the universe is not sneaking around behind your back and trying to exploit any hole in your models it can find. Businesses and the financial marketplace do exactly that with economic models.

Symmetry2• 14 years ago

I wouldn't say that economists have no idea about this, or that their theories aren't useful. No falling object you'll ever encounter actually matches the equation h = h0 - (1/2)gt^2 perfectly, but the equation is still useful. If the efficiency of a market is limited by computational constraints, well, we already knew it was limited by transaction costs, so while this finding is interesting it doesn't change how we should view the world.

wamatt2• 14 years ago

Honestly - since your profile advertises "Calling out bullshit in your own thinking and everyone else's is a very important skill."

Let me help try help you out :). Here are some more of your quotes:

'Everyone is ruled by incentives'

'If it's a derivative of a psychological bias <...>'

Rather strange to be making claims involving incentives and psychology, for someone that rules everything outside the 'hard sciences' as bullshit.

(FWIW I studied math, cs, applied math and physics at varsity but learned a great deal of knowledge that corresponds well with reality, outside of those fields)

confluence18• 14 years ago

You'll notice I said until further notice. This does not preclude from a) understanding psychology or b) being wrong.

Hence - until further notice everything I have ever stated is probably wrong and biased.

Just like everyone else.

pron7• 14 years ago

This stuff shows absolutely nothing. The author misrepresents what an efficient market means and then "proves" a tautology about it. (see my other comments, but it basically erroneously understands an efficient market to be one which knows everything that is knowable about the past, and then shows that that must include NP-hard problems.) Whether economics has any merit or not is a different issue, but this paper proves absolutely nothing.

tatsuke9513• 14 years ago

>"Economists have essentially no idea what is going on"

Complete and utter nonsense. "You" don't know what's going on, and assume others don't. The public is unbelievably ignorant of this subject. These men are brighter than you think.

>"EMH is by far the clearest example of this"

EMH is a 50 year-old theory. Like practically any other subject, economics that is taught in school at low-levels is based on old science. There is real, modern research happening on real-world things, just go poke around the Fed's site to see what they're doing.

confluence18• 14 years ago

You're probably right. I've only done graduate level courses in economics and finance so there might be PhD level stuff I'm unaware of.

I only have one question. If they know what they are doing why do we still have financial crises?

dingfeng_quek4• 14 years ago

EMH is actually a hypothesis (not a theory) that arises from non-arbitrage models. It's not meant to describe the real world, although it's thought-provoking to look at how "efficient" real markets are, so people like to characterize and "test" the EMH in its various forms. How markets fail to be "efficient" is often quite instructive for practical purposes.

For pedagogical purposes, I think it's a really good simplified and ideal illustrative model, until you learn the more axiomatic derivations of no-arbitrage (the arrow-debreau stuff). From your other posts, I gathered that you're not beyond undergrad studies in economics - you'll likely learn about the more complex models when you reach a more advanced and rigorous stage, if you pursue the theoretical path.

If I were you, I wouldn't be too concerned about others arguing about the EMH - without the proper foundations, you won't understand them beyond a superficial level.

Not to mention that it's popular for the less educated to bitch about the EMH, probably because it's an English acronym with commonly used words. I've almost never heard laymen talk about how unrealistic the nash equilibrium is (:

pron7• 14 years ago

To me stuff like this actually shows how some hard-science people apply autistic-like literal interpretation even to things that do not lend themselves to literal, narrow, interpretations. I'm sure, though, that many hard science people can expand their horizons enough to absorb different kinds of knowledge, too.

confluence18• 14 years ago

True no doubt.

But you do assume that I don't know these other types of knowledge when in fact I do.

Your open mind argument can be applied to spiritual and alternative medicine just as well - all knowledge is not equal.

anonymouz2• 14 years ago

But the author claims that something is equivalent to P=NP! Now, P=NP does have a very "literal, narrow interpretation" (read: it has a very precise meaning), in fact, this is the only interpretation in which it makes sense at all.

So if you claim that something is equivalent to it, you better be prepared to define what exactly "something" is, and give a rigorous argument as to why it's equivalent. Some hand-waving with vaguely defined and ambiguous terms just doesn't cut it.

meric6• 14 years ago

  "Economists have essentially no idea what is going on and 
  neither do their financial compatriots and the EMH is by 
  far the clearest example of this."

You only learn about EMH in first or second year in university; It is debunked in later years. It's like how you get taught first newtonian physics then later on when you're taught relativity, you learn that newtonian physics is not quite right but for many cases it is a good enough approximation.

  "I shake my head in disgust at those who apply platonic and 
  unrealistic theories to the extremely complex system that 
  is the world. "

That is unfortunate. Markets are extremely interesting to study. A market is a powerful machine very good at resource allocation. It is the third example of how simple interactions can give rise to computational power. The first two being "evolution" and "the turing machine".

confluence18• 14 years ago

You sure about the latter model being taught? Behavioral finance still doesn't feel like a first class citizen in most places.

sethrin• 14 years ago

I admit to little knowledge of economics, but to me it seems as complex a system as weather, without the underlying physical certainties.

My reading of Fama and Mandelbrot seems to indicate that markets are essentially random and unpredictable. Being largely uninformed on the matter, though, I would appreciate any explanation of Mandelbrot's theories and their relevance to the topic at hand, as they seem to have been largely ignored by economists -- I could not speculate as to why.

To me the tools of chaos theory seem apt to describe markets, insofar as they may be described. If they happen to yield no useful results, I would believe that such may not be obtained. I would appreciate correction on this matter.

Symmetry2• 14 years ago

Does this actually contradict the weak form of the EMH, that "future prices cannot be predicted by analyzing prices from the past"? If it's computationally unfeasible for the market to incorporate new information, surely its then equally computationally unfeasible for some outside observer to predict future prices? I'm not sure this even contradicts the semi-strong form of the EMH, though it clearly does rule out strong EMH.

confluence18• 14 years ago

Weak form EMH is so pointless so as to be essentially useless in predictive value.

It's like those horoscopes that state - "you will meet someone of great personal importance soon!"

michaelochurch• 14 years ago

Efficient Market Hypothesis isn't very well defined. It's more like a class of assertions, some of which are demonstrably true and some of which are false. Loosely speaking, it says the market price of an asset (or exchange rate between two assets) will be fair, which means that it corresponds to the expected value of its basic value. If you're talking about a bond, you can look at the (known) payment stream, discount the cash flow, and compute a fair value based on known market conditions. For an equity, there is no fair value other than "the expected value of its price in the future". Some stocks pay dividends, but many don't, so their values are based on something other than a current dividend stream, and largely that "something" is: what is the expected value of the thing in the future? The question is: what is the timeframe?

In the very short term, EMH is false for computational reasons. Efficient markets require someone (i.e. an arbitrageur) to keep them efficient. The profits of arbitrage are the incentive for people to keep markets as efficient as possible, and they tend to have this effect. This is an extremely competitive business, and in this day in age, it often comes down to microseconds, but it can be done and billions of dollars are made every day by people who are doing it (and, contrary to popular depictions, arbitrage is actually good for the markets and economy).

In the very-long term, EHM is probably also false. By very-long, I'm talking about 10+ years. The reason for this is rooted in the scarcity of money: there are a lot of projects and companies that will produce and capture economic value in the future, but people don't have enough money to fund them all. Hence, stocks are "cheaper" than they should be, and risky growth stocks (much less illiquid private equity) especially so. ("Equity premium.") There are some people who (demonstrably) "get" value investing and are better at predicting long-term corporate futures than others. The issue here is the long feedback cycle. If your frequency of investments is that low, you have no way of knowing if you're actually good, or just getting lucky, especially in the context of the non-normal (i.e. fat-tailed) distribution of equity returns driven by "black swan" events.

EMH is true enough that if you don't have the technical machinery to trade at microsecond latency, nor the reputation that will allow you to invest for the very long term despite market caprice-- i.e. even if the market tanks, people will trust Warren Buffett's judgment-- you probably can't reliably make a better profit on the stock market than you'd get if you invested in an index fund.

What does EMH rely upon? Ultimately, it says that if there is expectancy to be made selling or buying a security at a price other than P, it will be sold or bought until the price reaches P. This assumes an infinite amount of capital ("smart money") that people are willing to deploy in order to exploit pricing inefficiencies or inconsistencies. This is an obviously false assumption, but for liquid securities of known expected value, it's close enough. Leverage (borrowing) generates a lot of "additional" smart money, so that even a 20bp (0.2%) discrepancy can be levered up into a 10% gain. (If you have $100, borrow $4900, and turn that $5,000 into $5,010, your equity position has gone from $100 to $110.) Microprofit opportunities will be exploited so long as there's sufficient leverage to make them worthwhile, but the willingness of lenders is not infinite.

EMH is usually used to make mathematical analyses work. It's a guideline, but no one who understands financial markets believes it to be literally and universally true. No one can actually predict the future or human behavior, but the (false) assumption that there is no arbitrage produces closed-form numbers that are often very close to the real values.

Also necessary is the distinction between smart and dumb money. The latter isn't a pejorative; "dumb money" means that there are incentives other than informed speculation. For example, when you buy a house because you want to live somewhere, that's dumb money. Or when an index fund buys stocks because of its chartered requirement to do so, that's "dumb money", not because the buyer is an idiot, but because his purchase doesn't convey information about the stock's real value in the way that smart money would. Markets are efficient when there's enough smart money to keep the dumb flow from pushing the price around. This is going to be true of highly liquid stocks, currency rates, and commodities, but not true of assets like real estate. Financial engineers tend to discount "dumb" activity as harmless Brownian motion, but the 2008 subprime mortgage meltdown established that not to be always wise.

confluence18• 14 years ago

What happens when the smart money realizes that shorting a massive amount of dumb money would leave them freight trained by the crowds?

Smart money can be dumb as well - because it pays to do so. I'm quite sure that the number of rational investors/capital are greatly outnumbered by the irrational investors/capital such that many correct trades become essentially insolvent before the market becomes rational again. See value shorters for the last two booms.

mason55• 14 years ago

such that many correct trades become essentially insolvent before the market becomes rational again

Keynes was quoted as saying "Markets can remain irrational longer than you can remain solvent."

001sky3• 14 years ago

Money is never smart ex-ante, it is only such in hindsight (ie, ex-post). So this formulation is ~non-sensical. But to answer your question, the 'winning' strategy shifts from (measuring) "value" to (playing) "momentum".[1] This is not "dumb", but neither is it inconsequential from the perspective of political economy. Until you are in a position to explain this micro-analytically, you are left with vol expansion, which is arguably transparent and/or benign.[2,3]

_________________

[1] NB: information assymetries. By introducing and/or leveraging them, zero sum games can be more profitable than "fair games".

[2] http://en.wikipedia.org/wiki/Heteroscedasticity Heteroscedasticity does not cause...estimates to be biased, although it can cause...estimates of the variance (and, thus, standard errors) of the coefficients to be biased, possibly above or below the true or population variance. Thus, regression analysis using heteroscedastic data will still provide an <unbiased estimate> for the relationship between the predictor variable and the outcome, but standard errors and therefore inferences obtained from data analysis are suspect.

The maintenance of <unbiased estimate> preserves EMH.

[3] The arguments here are not trivial. But they are beyond the scope of many (if not most) professional "economists".

meric6• 14 years ago

Yes, EMH is likely to be as true as Newtonian physics. Both are good approximates but neither apply perfectly.

rayiner• 14 years ago

No, EMH is mostly a set of conjectures and very rough approximations. Newtonian physics is in a different universe of precision to the point where the two shouldn't even be in the same sentence.

001sky3• 14 years ago

A couple of other considerations regard the box in which this theory plays nice.

-- Behavioural assumptions of market participants

-- Preference Neutality with respect Volatility levels

-- Non-existence of externatlities from market microstrucure

These are avenues to be exploited, and the exploitations work better the more EMH is disseminated without "hypothesis" being spelled out. These are orthogonal directions of attack, but more dangerous and more powerful than many understand.

drfloob• 14 years ago

... and if P = NP, the market doesn't matter because everyone will have cracked all your bank passwords.

csense2• 14 years ago

From the paper:

> Now, one may argue that a weaker form of market efficiency as per Fama (1991) and Jensen (1978) is that patterns are exploited until the marginal revenue of further discovery equals the marginal cost of further search. A counterargument to that would be graduate students and other hobbyists and day traders searching for an edge: to them, the marginal cost is zero and at times negative because the value of the search itself, regardless of the outcome, is a positive learning experience for them...

A hobbyist has to spend more computation time for every additional strategy they search, which costs real money. The hobbyist's cost is near-zero for small searches -- those that can be done by one person using the computers they already own. Once the size of the search increases beyond what they can manage with their immediately available resources, they have to hire assistants and/or buy computation time like anybody else.

josephlord• 14 years ago

This is I think a bogus debunking of a bogus theory.

Try 'Debunking Economics' by Steve Keen for a good breakdown of real problems with many economic theories including EMH. Mostly by showing the logical fallacies in assumptions but also the naive maths and divergence from empirical reality.

http://www.amazon.com/Debunking-Economics-Expanded-Dethroned...

His blog is http://www.debtdeflation.com/blogs/

Markets are efficient if and only if P = NP

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