Wednesday, 17 November 2010

Blaming the EMH or not

I was reading a review on Amazon of the Roger Bootle book I mentioned t'other day. In it one reviewer said that the Madoff scandal was a result of the efficient markets hypothesis (EMH). I was rather taken aback by this, as the EMH is essentially a theory about how markets respond to information and what flows from this in terms of investors' ability to 'generate' superior returns (I prefer 'channel', actually, since it is the underlying companies actually doing the work). Madoff was, quite simply, a giant fraud and I don't see what a theory about how markets assimilate information has to do with that.

I was midway through posting a comment in response to the review when I read it properly and realised the reviewer was making a slightly different point. This was that the implication of the EMH is that other people are already processing the relevant information and/or doing research, and therefore there's no point doing the legwork yourself. This has merit in broad terms as an attitude to investing in developed markets. Unfortunately the reviewer stretches this to cover investors like Bramdean failing to do due diligence on Madoff, which I think is pushing things a bit far. Nonetheless the broad point is that a theory that says you can't beat the market because lots of other people are trying to and thus markets are efficient leads people to take their eye off the ball. I think there's something in that in broad terms.

But in the specific case of Madoff it doesn't really make any sense. Because if you read Nicola Horlick's infamous words about Madoff, one of the things she says is that he was very good at calling the market and therefore delivering sustained returns. Surely a real believer in the EMH would be deeply troubled by such a finding - because it directly contradicts the theory! Sustained outperformance should not be possible because markets are efficient.

In reality I don't think active asset managers (those who aren't shysters) believe in the EMH, at least in strong form, because they believe they can add value. The pitch of the likes of Nicola Horlick is precisely that they can do what the EMH says shouldn't be possible. That lack of belief in the implications of the EMH in turn lead Horlick to stick her clients' money in what she thought was a hedge fund (as I've said before, IMO it was no more a 'hedge fund' than Nigerian email scams are 'investment opportunities').

And if we take the broader point against the EMH seriously - that it leads people to do insufficient checks/research - how widely does this apply? If I buy a dodgy secondhand car because it's solid by what looks like a legit dealer and I assume they have done the legwork is that the fault of the EMH too? If not, why not?

None of this is to defend the EMH as a theory, and I do not underestimate the impact of ideas on behaviour. But it's worth thinking through what precisely the EMH did influence, rather than blaming it for behaviour that may have had other drivers.

1 comment:

Nick Drew said...

there are times when relying upon EMH (and a modicum of regulation) is all a punter can conceivably do

what is a fair insurance premium? 99.9% of punters could not wrestle with actuarial data even if they could be arsed - they must rely on the competitive nature of the insurance market, & get several quotes

in this, they are not badly served

PS the fighting-in-the-streets seems to have started ... it's taken a while; but then, it often does