Advanced Finance

Hot Tip!! Part 2

Last week I wrote about the efficient market hypothesis. In short, it states that the market (as a whole) is probably smarter, faster, and more efficient than you are (as an individual). Therefore, the notion that you can beat the market on a consistent basis is probably hogwash. But not everyone agrees with the EMH.

Points against EMH

I want to be transparent here; while EMH makes sense, it isn’t gospel. It’s just a hypothesis, and many economists are taking a scientific approach to poke holes in the theory.

For one, market agents can have biases, and sometimes those biases won’t “average out” over the whole market. An irrational excitement might sweep the entire market, and an investment might genuinely end up overpriced or underpriced, thus opening the door for a truly wise investor to move in and make legitimate money. Many experts point towards cryptocurrency as an example of this “sweeping excitement.” The true value of cryptocurrency surely didn’t rise and fall by 100’s of percentage points over the course of a one calendar year. So why did the price rise and fall that much? How does EMH explain that?

Image result for cryptocurrency
C’mon, it’s just a blockchain. You mine a coin, the transaction gets verified, and then your wallet get Bitcoin’d.
…right?

Another argument against EMH is that some investments are simply too complex for the market to get a solid grasp of. If only 10 people in the world truly understand a particular investment, then what are the odds that the entire market has evaluated it rationally? The EMH assumption of “too many agents, too much competition” does not apply if only a tiny number of agents have a proper knowledge of the investment.

Finally, some critics point towards individual events—e.g market crashes—as glaring evidence against EMH. If the market was all-knowing and efficient, then why was the Dow Jones above 14000 in October 2008, and then below 7000 by March 2009? Did the true value of the Dow Jones companies drop by 50%? Did they lose 50% of their sales, fire 50% of their employees, sell off 50% of their assets over those 5 months? Certainly not! Only the market’s evaluation of the companies dropped by 50%. The so-called “efficient market” changed its all-knowing mind by 50% in less than half a year!

However, proponents of EMH have explanations for these examples. In short, EMH is concurrent with the explanation that some investments are “too complex.” This complexity actually explains the “bias” or the “market crash” outcomes. Take cryptocurrency, for example. The value of cryptocurrency (according to a guy on YouTube) is based on complex mathematics and deep understanding of how value is assigned to an asset. It’s graduate level math and graduate level economics and graduate level YouTube (Don’t forget to Like and Subscribe!). It’s not an easy concept for most folks to understand. So when the cryptocurrency bubble expanded, it wasn’t based on widespread knowledge in a rational market. There weren’t thousands of knowledgeable investors saying, “I completely understand cryptocurrency technology, and I know why it’s undervalued.” Instead, it was based on irrational excitement towards previous gains, and the fear of missing out on future profits. Fear and excitement are not rational.

Similarly, the market crash of 2008 was heavily influenced by obscure and misunderstood investments in the housing market. Subprime mortgages and collateral debt obligations were, according to EMH proponents, intentionally designed to be complex and difficult for most market agents to understand. Information about these housing investments was kept hidden, or the information that was made public was inaccurate. In other words, the hallmark requirements of EMH—numerous knowledgeable agents and widespread information—did not apply to the 2008 Crash. And it was done that way intentionally. Large investment firms believe in EMH so much that they are trying to manipulate the market (create complex investments, keep information private) in order to prevent the market from efficiently evaluating their investment vehicles. By keeping information close to their chest, they believe they can fool the market and hoard the subsequent profits. EMH makes a lot of sense if the market is an even playing field. But if the assets are too complex, or the information about those assets is too far from the truth, then EMH might not apply.

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The Big Short sure made the crash of 2008 seem cool and edgy. Right Ryan?

EMH and You

So, according to EMH, what should we buy? First, just buy the whole market. There’s no long-term advantage to hand-picking individual stocks. Second, EMH concludes that paying high fees for “expert” opinions is simply a waste of money. Any performance  that is better than the market is simply random, like a monkey throwing darts at a board—the monkey might hit a bullseye, but does that make the monkey an expert dartsman? (Hint: no, it does not make the monkey an expert dartsman). Your best bet is to pay the smallest fees possible to buy a share of the whole market. How do you do that? They’re called index funds, and they have slowly been revolutionizing the financial markets since the 1970s. It’s highly likely that your 401(k) provider has at least one index fund that they offer to you. Check it out.

EMH also concludes that the markets for highly complex investments might not actually be big enough nor efficient enough for EMH to apply. So, yes, there might be opportunities for profit out there. But you still have to ask yourself, “Are you smarter than the other investors? Do you have information that they don’t? Are you sure you’re processing that information correctly? Do you think you can maintain this informational edge over the long term?” Those are difficult questions to answer, and even more difficult to answer them all in a way that suggests, “Yes, you should be making this investment.”

What do you think? Does the Efficient Market Hypothesis make sense to you? Or, if you know more about it then I’ve explained here, I’d love to learn. Please, feel free to let me know.

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About Jesse Cramer

I’m Jesse. I’m an engineer, a new owner of an old home, and an avid reader/writer. I hope you enjoy my thoughts, numerical breakdowns, and general musings. If you’d like to comment, ask a question, or simply say hi, leave me a message here, on Twitter (@BestInterest_JC) or on Reddit (u/BestInterestDotBlog). Many of my posts have been directly influenced by my readers. It’s the most fun part of writing this blog. And as always, thanks for reading the Best Interest. Jesse
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