Richard Thaler is quoted in the latest issue of The Economist saying the following about the EMH:
The first version basically says that when you trade on the basis of publicly available data you can only expect to earn the risk-adjusted return. This does not rule out fat tails, stochastic volatility or even bubbles. More technically:
.
where Qt+1 is a discount factor (containing investors preferences/risk aversion) and Ωt is a given information set. As you can see, we are only talking about the conditional expectation and not about the conditional variance, higher moments, or the shape of the return distribution. The message is that just because their has been a market crash that doesn't mean the EMH is wrong. [Actually, is there a reason why the intrinsic value of companies should not drop by half?]
The other question is what investors actually do with the information set at any give point of time. Was the information set we had in 2007 already screaming that house prices will crash and investors didn't make use of this information or did the extent of the problem only gradually build up in the information set?
The only thing I know for sure is that the more I think about this the less I think I know what I'm talking about. The good news is that I don't think I'm alone!
The [Efficient Market Hypothesis] has two parts. The “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.If I understand the paper Efficient market hypothesis and forecasting by Timmermann and Granger correctly, then the hypothesis does not have two parts but there are actually two completely different versions. The first one talks about informational efficiency, which is about forecasting, and the second one is built on the notion that the prices should reflect intrinsic values.
The first version basically says that when you trade on the basis of publicly available data you can only expect to earn the risk-adjusted return. This does not rule out fat tails, stochastic volatility or even bubbles. More technically:
.
E[Qt+1Rt+1 | Ωt] = 0
.where Qt+1 is a discount factor (containing investors preferences/risk aversion) and Ωt is a given information set. As you can see, we are only talking about the conditional expectation and not about the conditional variance, higher moments, or the shape of the return distribution. The message is that just because their has been a market crash that doesn't mean the EMH is wrong. [Actually, is there a reason why the intrinsic value of companies should not drop by half?]
The other question is what investors actually do with the information set at any give point of time. Was the information set we had in 2007 already screaming that house prices will crash and investors didn't make use of this information or did the extent of the problem only gradually build up in the information set?
The only thing I know for sure is that the more I think about this the less I think I know what I'm talking about. The good news is that I don't think I'm alone!
Mahalanobis - am 2009-07-19 19:39 - Rubrik: Finance
Eric Falkenstein meinte am 19. Jul, 23:21:
'Right' price?
I think all the 2008 crisis showed is that
E[QtRt | Ωt+1] <> 0
which isn't really interesting. With hindsight, the US housing bubble should have been anticipated, but it was not obvious, and even Shiller was not predicting a housing crash, only that housing would probably not continue at its recent pace. As to the financial multiplier that really siezed up the financial community, this is still only beginning to be understood. Note that a recent journal on the crisis by esteemed academics presents several independent explanations, and of course there are several books noting hubris, greed, too much regulation, too little regulation, wrong regulation, the Fed, etc. So, I think this crisis doesn't say much about EMH, rather, it is very important for understanding financial multiplier effects, and bubbles.Alternatively, one could argue that the Ωt is not so simple, and that with hindsight it contained all we needed to know. That we did not interpret this correctly in real time, however, points to an error with certain properties, certain general regularities over time.
The bottom line is that I think the 'right' price means only a price that a reasonable mind finds appropriate, where reasonable does not involve hindsight. This does not preclude 'rational bubbles', because these are bubbles that are only identified ex post, and this bubble was definitely not identified by any large consensus of reasonable people ex ante (in contrast, the famous 3Com-Palm split was identified ex ante, with an article in the New York Times when it was still there and many people made millions on it).
Teresa (guest) meinte am 20. Jul, 08:07:
From Experience...
...people never take action until something has *already* crashed. They always ignore the Cassandras.
Mark T (guest) antwortete am 21. Jul, 17:54:
but what do you think is the information set?
Your example assumes that had we "known" that house prices would "crash" then we could have avoided the market collapse. But this implies that house prices were the central cause of the problem. Sure this is the cozy consensus (but when was that ever right?) Leaving aside the dubious nature of Shiller's dataset ( it is way more pessimistic than the Census data and tracks the realtors' data of median distressed selling dominated prices too closely for comfort ) the problem was surely the "Insurance products" constructed on the back of the housing market. Even then, the crash was slow motion at best. We all saw the steady unravelling of the CDO squared markets. The meltdown in September October was much more to do with policy error - nationalising Fannie and Freddie thus bringing on the short equity long bond trade in all financials (with a "panic" buy of the CDS to trigger the downgrade/rights issue etc), then the banning of short selling, then the mugging of the WAMU bond holders, then the Lehman debacle that triggered the paralysis in the money market fund CP nexus that finally brought the real economy to a standstill. Just because the media and the economists think it was to do with the average value of a house in Michigan doesn't mean any of this was predictable. Hence the market was efficient, it reacted to a series of policy errors, not an economic forecast.
