No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Sixteen: Valuing the Future - Concepts in Capital & Finance 409 In our discussion of speculators in chapter 6, we learned how speculators lead to a socially optimal outcome when they correctly identify market mispricing; their actions tend to bring prices toward an equilibrium position. When they are wrong, their actions will lead market prices away from equilibrium. Their error will result in financial loss; they are thus incentivized to speculate correctly. But the discussion in chapter 6 did not address the timing of speculators’ actions. For speculators to gain the highest profits, they need to act quickly to arbitrage the price back towards a new equilibrium. Imagine that the price of oil is currently $60 per barrel, and one entrepreneurial speculator believes it should be more like $80. If she is correct but doesn’t act until oil has risen to $70 per barrel, she has lost 50% of the potential profit. If markets have mispriced resources, the quickest speculators make the largest profits. Hence, markets tend to move very quickly. As we’ve said, markets often react within seconds to new information. In one study , economists found that those that could make a trade within 15 seconds of new information presented on CNBC could still make significant profits, while the new information was fully embedded in a stock’s price within one minute! Given that every market has millions of potential investors bringing new knowledge within seconds to the market price, markets are often said to be “efficient” in that the price of an asset fully reflects all available information. The efficient market hypothesis (EMH) has three versions as to how much information is available. The range is the following: 1. Weak form EMH : suggests all past information is embedded in the current price 2. Semi-strong EMH : suggests all publicly-available information is embedded in the current price 3. Strong form EMH : suggests all information, both public and private (including insider knowledge), is embedded in the current price The most important implication of the latter two forms of EMH is that if prices fully reflect all available information, individual investors cannot beat the stock market, on average. This implication leads proponents of EMH to assert that individual investors should not try to “beat the market” by picking individual stocks, but should invest in a broad index of stocks. There is certainly a lot to say for this approach. If there are millions of very smart people constantly trying to evaluate the price of assets who will quickly arbitrage any price discrepancies away, what chance does an average investor have to beat the market? The answer is, not much. In fact, most professional stock pickers do not do as well as simply buying and holding an index of common stocks. So the central conclusion of EMH seems to be sound advice to potential investors: since markets are constantly pricing in new information, and the price of an asset therefore reflects the consensus of millions of investors, it is hard to beat the market. Nevertheless, there are a number of conclusions that people have drawn that are not necessarily true. First, EMH proponents suggest that since the market price already Efficient Market Hypothesis: Markets are said to be efficient if prices fully reflects all available information