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

Chapter Sixteen: Valuing the Future - Concepts in Capital & Finance 410 reflects all available information, the price is correct; efficiency in information processing means efficiency in forecasting future outcomes. Any change in the future, say EMH proponents, is purely random and therefore there is no way to systematically beat the market. Critics of EMH have two words to respond to that: Warren Buffett (the famed investor who usually beats the market). Proponents of EMH will then respond, “well, in a large pool of active investors, there must be someone on the probability distribution who gets it right for years on end.” In other words, EMH proponents say it is still a matter of luck that we find some investors like Warren Buffett who consistently beat the market. Yet most people that watch Warren Buffett think his results are not due to luck, but rather his shrewd business acumen. A second conclusion is a corollary of the idea that markets are efficient and the prices are always right: we will not see stock market bubbles and associated wild swings in asset prices. A market bubble is when asset prices rise greatly above any fundamental value calculation, such that when the mania ends, prices of those assets fall dramatically. Yet, most observers find the stock market crash of 1987, or the boom and bust of tech stocks in 1999/2000, or the financial panic of 2008 as examples of stock market inefficiency. Another rebuttal to strong EMH conclusions is that the very theory is self-contradictory; for markets to equilibrate, there must be someone to act on the initial information—that individual makes above average profits. For EMH to apply, someone must act. Yet if EMH were true, there would be no incentive to act since there would be no way to beat the market. The contradiction is wrapped up in this tale of two University of Chicago economists (who generally are the strongest proponents of EMH) walking down the street. One economist said to the other, “look, there is a $100 bill on the sidewalk.” The other economist responded, “there can’t be. If there were a $100 bill, someone would already have picked it up.” Obviously this is contradictory; if there is an opportunity to be arbitraged, there must be someone to arbitrage the price difference away. This applies just as much to financial assets as to oranges priced differently in different markets. To understand how applicable EMH really is requires reflection of our early discussion of risk vs. uncertainty. A world that is characterized by risk has known possible outcomes associated with a probability, while a world of uncertainty can’t claim knowledge of either. If we live in a world of risk, the informational efficiency that is so clearly demonstrated in most empirical studies will lead to correct market prices. If, however, we live in a world of uncertainty, EMH simply means prices are the best we can know today—but they may or may not be correct tomorrow, and prices may diverge sharply when entrepreneurial expectations change. Note that in a world of risk, entrepreneurial expectations have little role; after all, every possible outcome is known, as well as the possible outcome. But in a world characterized by true uncertainty, entrepreneurial expectations are the key driving force in the allocation of capital.