The Invincible Markets Hypothesis

Introduction (via Ravi Sethi)

There has been a lot of impassioned debate over the efficient markets hypothesis recently, but some of the disagreement has been semantic rather than substantive, based on a failure to distinguish clearly between informational efficiency and allocative efficiency. Roughly speaking, informational efficiency states that active management strategies that seek to identify mispriced securities cannot succeed systematically, and that individuals should therefore adopt passive strategies such as investments in index funds. Allocative efficiency requires more than this, and is satisfied when the price of an asset accurately reflects the (appropriately discounted) stream of earnings that it is expected to yield over the course of its existence. If markets fail to satisfy this latter condition, then resource allocation decisions (such as residential construction or even career choices) that are based on price signals can result in significant economic inefficiencies.
Some of the earliest and most influential work on market efficiency was based on the (often implicit) assumption that informational efficiency implied allocative efficiency. Consider, for instance, the following passage from Eugene Fama’s 1965 paper on random walks in stock market prices (emphasis added):
Favorite Bit (Via Ravi Sethi)
But a name that emphasizes informational efficiency is also misleading, because it does not adequately capture the range of non-fundamental information on market psychology that prices reflect. My own preference (following Jason Zweig) would be to simply call it the invincible markets hypothesis.

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15. February 2010 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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