What Is the Efficient Market Hypothesis?

Brad DeLong cites Underbelly citing The Economist quoting Richard Thaler:

The [Efficient Capital Markets] hypothesis has two parts, he says: 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.

I think this is exactly right. Ever since graduate school I have said that I believe in efficient markets, by which I mean the “no-free-lunch part.” The idea that some people might think that “no free lunch” implied that “prices are right” didn’t even occur to me at the time. My thinking was basically like this: yes there are bubbles, but it’s hard to tell if you are in one, and even if you can tell, you can’t tell how long it will last so you can lose a lot of money betting against it, and even if you have a very long time horizon, who’s to say you won’t be in another bubble when you finally want to sell? Put another way, you may be “right” about an asset price, but if the market is composed of lots and lots of people who are “wrong,” and those people are never going away, what does that get you?

More fundamentally, for an interesting asset like a share of stock (or a house), what does it even mean for a price to be “right?” Sure, ten years later you can see what the dividends have been for ten years and what the stock price is on that date, but that price is no more “right” than any other price; it’s still a collective, irrationality-tainted guess about the future. Future states of the world are not only unknowable right now, they dont’ exist right now, so questions of right and wrong don’t even apply to them. There are just better and worse estimates, and there will never be any way to determine which estimate was better. (Just because things work out a certain way doesn’t imply that that was the most likely outcome.)

I think I’ve beaten this question into the ground recently, so I’ll stop there.

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About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

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