Monday, January 11, 2010

Efficient Market Hypothesis and criticism

IN a recent blogpost the odd and quirky Robin Hanson discusses How To Dis EMH (Efficient Market Hypothesis) and (more importantly) - how not to. He shows some quotes of the debates going on and argues that you cannot judge EMH unless you can at the time do better than it and prove that you can do this consistenly over time.

So the clearest way for EMH skeptics to show they are right is to collect a track record showing that they can predict, ahead of time, when prices are too high, vs. too low. There’s little point in picking out some year old event, and saying, “see that price drop was too big.” Monday morning quarterbacking is way too easy.


But all this continual harping year after year on how EMH is obviously wrong, based on selective stories of past prices you say were obviously wrong, sounds awful suspicious when you don’t bother to publicly flag price errors at the time, much less to collect and publicize a track record of such error flags. (E.g., care to declare which prices are wrong today?) What’s up with that?

It's an interesting point that I agree with to a point, but there's something odd about it as well. I think it may have something to do with what we mean by "criticism of EMH". Hanson's point is valid if a critic says that the EMH is often obviously wrong and can easily be improved. But what if a critic says that the quality of forward looking predictions (including his/her own) is generally poor, and that this translates into an extreme volatility in stock markets and markets in futures and derivatives? If this is so, and if there are significant and real costs to sharply and vigorously yanking the economy towards whatever-our-best-guesstimate-of-the-future-is-right-now, then we might not want our economy to be as dependent on the estimates of the future. We may be able to choose or influence at a social or policy level how "forward looking" our economy is in its adjustments - and we may not want the ADHD economy that wants to pull up all roots and set sails towards whatever the future seems to hold at any given instant.

1 comment:

  1. Yes, we might want our economy to be more robust to price errors, but if predictions are poor, and so volatility high, EMH can still be right.