Efficient markets: paradox or red herring?

John Quiggin claims that the efficient market hypothesis is refuted. I fear, however, that there’s a distinction here that’s being elided.
The claim “markets are inefficient” can imply at least two things:
1. The job of allocating capital to investment projects will be badly done by markets.
2. It’s possible for an individual to out-perform stock markets without taking on extra risk, by spotting under-priced assets.
John’s focus is upon (1). And the bubbles in dot coms and mortgage derivatives seem to vindicate him.
But point 2 is much less obviously true. Equity hedge funds have done poorly and the majority of UK all companies unit trusts have under-performed tracker funds in the last five years. This suggests that it’s much harder to spot mispricings than claimed.
This gives us a paradox. On the one hand, the efficient market hypothesis seems obviously wrong; prices deviate massively away from “fundamentals.” But on the other hand, a major implication of the efficient market hypothesis - you can’t beat the market -  seems good enough for practical purposes.  An investor who believed in efficient markets would have avoided the worst catastrophes of recent years.
What’s going on? The answer, I suspect, lies in the fact that there’s an almighty difference between knowing that markets are irrational and being able to profit from this fact. For example, even if we grant that excess volatility is a sign of market inefficiency - and it might not be - there’s very little investors can do to make money from this. As John says, it was easy to lose money betting against the dot com bubble.
Which raises a question.  Could it be that the EMH is a red herring? Could it be instead that all of us suffer from severely limited knowledge and rationality, with the result that capital cannot possibly be allocated efficiently?
If so, our choice is between mistakes made by markets and mistakes made by government - a choice that might, reasonably, vary from context to context.
And in this particular context, it might be that the mistakes caused by market bubbles are tolerable. As Daniel Gross argued in Pop!, they can have beneficial effects.
* Apologies for my unexpectedly long absence. I've had the lurgy. If you believe that past risks are a good guide to future ones, the fact that I've now recovered shows that I'm immortal.

Comments

[dearieme]

"This suggests that it’s much harder to spot mispricings than claimed." Oh, I don't know - I've found the writings of Andrew Smithers very helpful. I suspect that your mistake is to assume (or pretend to assume) that investment managers are actually seeking mispricings, rather than just seeking more mug punters.

[Morgan]

[Hope you're feeling better Chris]

[ortega]

And I thought that you were taking some very long holidays !
Best wishes and take care !
PS: I'm decided to be inmortal. So far so good.

[Matthew]

I've not really managed to think this through properly, but aren't the two related? If the market return is a weighted average of the individual returns, then (depending on the distribution) many or most players won't beat the average. But surely the return on shares is only one type of return - companies are taken private, investors get returns on other assets etc, and so perhaps the only real measure of how 'efficient' something is would be the total return compared with another world in which different decisions are made, perhaps about investment or economic structure?

That's not very clear. Another thought was that on average people can't earn more than the country's GDP per capita. But I'm not sure what that says about our economy's efficiency.

[kinglear]

I think that with fairly small sums ( a few million) it is possible to do really well - the problem is with billions its impossible to get in and out when you should ( viz all the people in Bank shares)
That said, many years ago a revered Swiss Banker told me that there were only two things that mattered - one was the sector and the other was the currency. Movements in either of these dwarfed all others.

[kinglear]

Ps sorry that nice looking girl has gone....

[Chris E]

As above - the two are linked aren't they? After all, in order for individuals to consistently beat the market they have to be able to spot arbitrage opportunities - either over the long term or short term. If the market as a whole could spot these then they wouldn't exist - and neither would bubbles.

[Russell]

I thought Mandelbrot already showed the efficient markets hypothesis was wrong. There is long term dependence and discontinuities (i.e., prices jump). However, this does not imply that people can "beat the market" in the long-run, though certainly many do (although a lot of them may just be lucky and not actually skilled).

So I agree - what is a better mechanism for aggregating decision-making and human action - the market or government? Well, it depends on the issue, but 9 times of out 10 I think the market is better.

[Bob B]

Welcome back, Chris.

S&M: "This suggests that it’s much harder to spot mispricings than claimed."

How come these quotes then?

"Another anomaly exists in the form of the investors who beat the market soundly on a long-term basis, including Peter Lynch, Warren Buffett, George Soros, and John Templeton. Warren Buffett has commented that 'I'd be a bum on the street with a tin cup if the markets were always efficient'."
http://en.wikipedia.org/wiki/Efficient_market_hypothesis

"Nobel laureate James Tobin reports that one of his Yale students went to work for the Chicago Mercantile Exchange as an assistannt to an active trader who was a former economics professor. After a few weeks, the young man asked about the long-run calculations that governed the trades. He was told 'Sonny, my long-run is the next ten minutes.'"
Robert Solomon: Money on the Move (Princeton UP, 1999) p.14.

I thought that one of the significant insights of Mandlebrot and (Black Swan) Taleb was that, in fact, stockmaket risks are not normally distributed and the actual distributions have fatter tails - meaning that extreme outcomes are more likely than with normal distributions. Taleb's claim is that most hedge funds are using market models which assume normal distributions of risks.

[Bob B]

If only we all had taken heed of this warning in 2003 about derivatives from Warren Buffett:

"The rapidly growing trade in derivatives poses a 'mega-catastrophic risk' for the economy and most shares are still 'too expensive', legendary investor Warren Buffett has warned."
http://news.bbc.co.uk/1/hi/business/2817995.stm

And this from 2002 about the house-price bubble:

"CHARLES GOODHART, a former member of the Bank of England's monetary policy committee [and economics prof at the LSE], warned yesterday that the Bank is failing to take sufficient account of the house price boom in setting interest rates.

"His warning comes amid growing fears among economists that house prices, fuelled by the lowest interest rates for 38 years, are getting out of control. Yesterday, new figures showed that homeowners are borrowing record amounts against the rising value of their homes. . . "
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2002/04/06/cngood06.xml

Keynesianism is in the news. As Keynes summed up in this quote his personal take on whether markets are rational, "markets can stay irrational longer than you can stay solvent."

[Bob B]

Just out:

Martin Wolf: Fixing Global Finance (Yale UP, 2009) - and with huge endorsements on the dust cover from Larry Summers and Kenneth Rogoff amongst others.

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