Efficient Market Hypothesis (EMH) Problem

8/13/2019 Efficient Market Hypothesis (EMH) Problem

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In this email I explain why i bash EMH, or the

efficient market hypothesis, and give some

advice. You dont have to agree, but I owed it to

you since I degrade it so often.

Economics is foremost a social science.

Compared to the hard sciences, economics is in

an infantile stage, or early dialectic. The modern

view of economics was developed by adam

smith in his "wealth of nations" in 1776. His

concept of invisible hand is the crux of the book,as well as modern capitalism and economics.

The theory of the invisible hand is a

generalization that people pursuing their self

interest creates a perfect resource allocation, or

equilibrium.

Future economists with "physics envy" followedup on equilibrium and created pseudo-scientific

models.

The axiom of rational expectations says that a

persons expectations are equal to true

statistical expected value. As to say, when a

girl goes shopping, her purchase corresponds

exactly to statistical expected value.

Furthermore, statistical expected value in itself

is illusory, as it is the random variable we would

expect over an infinite sample divided by the


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average. How often is there an infinite sample

size? I will admit, post-modern and econometrics

have created some complex models; but as the

saying goes, garbage in-garbage out.

Another reason economics is psedo-science is

that it is modeled after Newtonian physics,

which is erroneous. Newton was observing

physical matter with no thought process. As

soros has recognized with his reflexivity theory,

humans have a feedback loop betweencausation and cognition, which cause boom bust

cycles(aka far from equilibrium). It is no

coincidence that economic models dont predict

the future; which is clear when even alan

greenspan says no one could have predicted the

housing collapse.

Modern financial theory drew from economics in

the 1960s. Its paradigm has been the EMH. EMH

is the view that the market is always correct

either through all public past, public current, or

all information. That it predicts the future in an

infallible manner. But this is a paradox. The

mechanism for creating an accurate price of asecurity comes from market participants

searching for positive npv. If everyone believed

in the EMH, then fundamentals would be


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abandoned, causing the security to be

mispriced.

CAPM is said the discount rate used in the EMH

paradigm. It states that a more risky security

should have a higher discount rate. That is a

rational statement, but its methodology is not.

Below is the formula.

Expected return = risk free rate + beta x (market

premiumrisk free rate)

Beta is essentially the volatility contrasted to

the market. Meaning we are defining the risk of a

stock by its price movement. This is retarted.

Let me provide two examples.

1. A recently public tech company has came out

with one service that is not yet monetized.Mangement claims it will be no problem and that

they have many great ideas in the pipeline-

people are excited. Say they IPOd at $20 and

given the economic cycle of many other

industries that constitute the market risk, its

relative volatility has been equivalent to the

market, providing a beta of 1. This means that

for a non-monetized business, in an industry

prone to creative destruction, it has the same

riskiness as the overall market(You could use

the NASDAQ).


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2. There is a bluechip in the food production

industry that has had a large selloff due to a

housing and financial sector bubble. Many of its

shareholders are older and have been using thedvd reinvestment plan for years. Due to the

income-needs to finance retirement, many sell.

This creates a greater volatility relative to the

market. Essentially what is happening is that a

business thats been around for years and is

going nowhere has a stock that is a good value,

but CAPM says its expensive.

In 2004, the creators of CAPM stated that the

failure of the CAPM in empirical tests that most

applications of the model are invalid.Sadly its

still taught as fact in finance courses. And you

should not think for yourself-let the ivory-tower

guys handle it

Post modern finance has recently created

behavioral finance and the adaptive hypothesis

theory. Im not gonna discuss it, but it is a step

forward from modern finance theory.

Ive bashes a lot of the theory thus far but have

yet to give any solution. I dont have one

particular solution because each persons risk

tolerance and investment acumen is different.

But for those that have the ability and desire for


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risk, the right mind(analytical, critical thinking,

emotional intelligence), and time to invest

should have a more concentrated portfolio.

Think about it, how many billionaires wereinvolved in 100 businesses? You can decrease

diversifiable risk away largely with 15

companies. You dont need the 500.

What matters is that you know the business.

Think of it in terms of a zero-sum game. If you

are selling then someone is buying. Why? Whatmight you be missing? What is your hypothesis?

What is your valuation of the stock? Are you

being conservative in your estimates? How does

your hypothesis differ than the market? You

need to be able to answer these questions.

A good way to get an edge is to specialize in aspecific area. Perhaps the industry you work in.

perhaps a hobby of yours-which peter lynch

advocates. Perhaps a specific situation that

companies face.

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Efficient Market Hypothesis (EMH) Problem