Wrong but very useful: the efficient markets hypothesis

Personal finance tip to folks who have some money saved up: Don't throw the baby out with the bath water by completely dismissing the Efficient Markets Hypothesis (EMH). See the end of this post for what I mean in practice.

I cannot resist commenting on an article in today's Globe & Mail (Taking Stock, Brian Milner) entitled, "Sun finally sets on notion that markets are rational". Milner is reviewing a new book, by Justin Fox, whose cover appears in the figure. In summary, Milner writes that EMH, "has finally been buried under an avalanche of unforeseen calamities, uncontrolled greed and other seemingly irrational behaviours it couldn't possibly explain."

What's this all about? Well, the idea behind EMH is that you can't beat the market. Efficient means that the price of an asset that you observe in the market is all you know and you can't predict the future price. Why? Because if a stock or some other asset is under-priced, somebody would take advantage of that and buy it, pushing up the price until there was no longer any profit to be made. So the prices you observe in the market are the "right" prices in some sense. Economists have thought quite deeply and extensively about this idea.

Now, we also know in practice that this hypothesis is wrong. But it is nevertheless an extremely useful hypothesis in the sense of the physicist Wolfgang Pauli, who once famously ridiculed a theory by saying that it, "wasn't even wrong". Let me give you an example of why we know this hypothesis is wrong. As a trader I would often get customers who were not interested in maximizing their profits solely in the financial markets. For example, they would tell me to buy X shares of a stock now. I might tell them if they took a few hours to work their order they could get a better price. They would come back to me and say, well, my staff is busy and they need to work on other important things, so I don't care if you buy X shares and drive up the price somewhat, just fill my order now, please. After I fill the customer's order, I'm 90% certain that the share price is going fall back down, contrary to the efficient market hypothesis.

So why is the EMH wrong but still useful here?

The answer is that anybody else looking at the market for the stock cannot know that the stock is going to rise or fall. They don't know if I'm finished with my order, or if I have a lot more shares to buy. Unless they can deduce something about what I am doing, the market appears to them to be efficient, meaning there is no profit, on average, to made by betting on the direction that the stock price moves. Furthermore, EMH is useful because it implies that you should always have a healthy respect for the market and the prices you observe in a freely trading, liquid market. It leads to the following rules, which I think of as the trader's practical version of the efficient market hypothesis (applicable to liquid markets):

The market usually knows more than you do. You will lose money if you casually think otherwise.

And a corollary,

Unless you do your homework, the best you can do is rely on the prices you observe in the market.

So, what practical advice can I give, especially to all those people who have some money saved up but have better things to do with their lives than worry about their investments? Well, I'm pretty confident (i.e. I would tell my mother to do this) that markets are still efficient enough to say, don't pay somebody to pick particular stocks, bonds or other investments. Invest passively in index funds that have low management fees. Think twice before spending a lot of your own time on stock-picking, market-timing or trading instead of on something else that might be more valuable to you and other people in your life.