Mistaken Efficient Market Hypothesis or Theory (EMT)
"The EMT is the Problem"

 

Nassim Nicholas Taleb, author of The Black Swan (2007), correctly argues that unexpected events with “fat tails” are more likely, than accounted for in Wall Street risk management models. However, the real problem with current risk management models goes much deeper. Rather, they use the mistaken efficient market hypothesis or theory (EMT) to represent markets as efficient, always in equilibrium and self-correcting where security prices simply react to random news releases. The EMT models individual security price movements as random variables where a purchase or sale results in neither the buyer nor seller having an advantage. Thus, security trading is like casino gambling where price volatility decides risk assessment. The EMT assumes that because prices always reflect intrinsic value and it is impossible to know what markets are going to do, So, fundamental analysis is not cost effective. The EMT model is both naïve and specious. It relies on false premises and, therefore, cannot correctly model market risk.

 

Markets experience disequilibrium and are not self-correcting but rather discount the future. Professional traders look ahead and bid prices either up or down before earnings and/or economic news announcements. Prices can increase on bad news and decline on good news. Security prices from day to day seem random. Markets have only systematic risk because diversification cancels unsystematic risk. Using a diversified market portfolio, monthly rather than daily data, trend lines and conditional probabilities based on fundamental analysis correctly models systemic market risk. Disqualifying the flawed EMT’s reliance on securities’ price frequency and the use of price volatility as a proxy for portfolio risk, which is not enough information when hedging positions.

 

Financial computer models depend on the EMT, explaining why false theories have major effects, conceivably, even being the cause for this GREAT RECESSION. Financial risk modeling has an interesting almost haphazard history, which further complicates bank “stress testing.” Harry Markowitz is the father of modern portfolio theory, receiving a Nobel Prize in Economics in 1990. His 1952 paper, in The Journal of Finance, assumes market efficiency.  Markowitz’s theory relies on stock prices being random variables and normally distributed stock returns, allowing mean and variance to be the only two measures that investors need consider. High mean, is desirable, and equated to “expected return” and high variance of return, is undesirable, and assumed to model “ risky-ness of the investment.” Markowitz does not explain why variance/standard deviation measures of price volatility is a good proxy for the “risk of loss.”

 

Many criticize using volatility measures for risk measurements, because that assumes knowing nothing about the company’s intrinsic value. Volatile stock is mean-variance risky. If this company’s intrinsic value is high and the stock price drops to the low of its range, the stock is now a buy and a less risky purchase. Markowitz has a mathematical solution in search of a problem, or as Yves Smith says, “computational convenience trumps empirical findings."

Please see Dr.Prentis' published research paper for more on the Efficient Market Theory and the credit crisis.

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