Efficient Market Hypothesis
Wed Aug 10 2022
Since Adam Smith’s “The Invisible Hand”, economists grappled with useful abstractions of the market. Efficient Market Hypothesis is one of those abstractions. According to EMH, all information available to the market is priced in. The only way to make money is through insider trading (non-public information). This is like a Cantillon effect for information. Those who have it first benefit the most. This abstraction is useful for non-market participants. It describes how the market can arrive at the correct price. For market participants, you are one of the many parts that create the effect of EMH.
Physics and Information
If we use a physics analogy, EMH describes Newtonian physics — given a position and velocity and the presence of forces such as gravity, determine future position. It is astoundingly accurate. However, the underlying forces that create the effect of Newtonian physics is quantum and doesn’t care about what Newtonian physics predicts. Market participants are the quantum mechanical effects, EMH is what we observe about the result of the individual market participant actions. As an approximation, EMH is far off the mark. If EMH was correct, irrationality would not exist in the market. EMH is an asymptotic goal that reality never quite reaches and sometimes does not even get close.
There is no such thing as perfect information. Information absorption through the medium of humans depends on the structure of information propagation (media, word of mouth) and each person’s resistance or adherence to a particular piece of information based on their current world model. Variability of information creates dramatically different information states in individuals. After information absorption, the individual’s world view needs to be updated and determine if the information is actionable. Individuals make very different decisions based on their biases and existing world view.
High Weight Individuals
However, not all individuals participate with the same weight in the market. Those who price assets closer to real value will accrue more capital and will consequently develop more weight in influencing price closer to Efficient Market Value. This compensates for the individuals who price farther from EMV.
All models are inaccurate and over time accrue errors. Errors in determining EMV will persist over longer time period if the pricing is done by high weight individuals (HWI). HWIs are usually net positive contributors to EMH but their weight and momentum (incorrect models) can create long periods of incorrect pricing. A dramatic collapse of a once-reputable hedge fund or financial institution is almost always a correction of a HWI’s error in determining EMV.
Profit from the spread
Market inefficiencies persist, information takes time to be absorbed and few agree on the interpretation of the underlying data. Converting data into signal is an art. Information which is hard to digest is where the biggest interpretation ambiguity lies. Successfully interpreting difficult information before others allows exploitation of information asymmetry. In particular, niche markets that are not yet in the spotlight of large funds provide abundant opportunity for profiting from information asymmetry.