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
