Musings on Efficient Market Theory

Justin Fox, author of The Myth of the Rational Market, is in an interesting interchange with Eugene Fama, patriarch of efficient-market theory.

Which led me to some musings on the subject.

I find that a great deal of the discussion of EM theory is befuddled because the discussors don’t distinguish clearly between different but related statements:

1. You can’t know whether the price is right.
and
2. The price is right

or

1. Individuals are rational actors
and
2. In aggregate, individuals’ actions effect the market as if they were all rational actors.

Another thought:

While all (or enough) first-order information might be “in the market” to set prices “efficiently,” what about the potentially more profound effects of second-order information: “I believe that you believe”? Or even more, “I believe that you *will* believe.” (See “Greater Fool.”)

This information obviously cannot be known, or known with any accuracy or certainty. And it is arguably far more powerful–at least in the short term–than first-order information.

And yet another thought, re: herd behavior. It’s been shown that groups of individual actors, with each actor operating under very simple algorithms, can create very complex (and generally unpredictable) behavior by the whole group.

So each bird in a flock operates with rules like “if I’m on the outside of the flock (no bird on one side of me) and the bird next to me moves away, move towards that bird.”

The result is the quite remarkably cohesive behavior of bird flocks.

Now, assume that our investing algorithms are based largely on people’s (inherently unreliable) second-order beliefs. (“If I think you think the market will go up, I should invest.”)

Life gets very, very complicated…