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Monday, July 09, 2007

Efficient vs. Adaptive Markets (and a Joke)

"Classic" finance theory says that markets are efficient (that prices reflect all available information). However, real-world data reveals a lot of patterns that seem to contradict market efficiency - like the small-firm and value effects, post-earnings announcement drift, momentum effects, and so on.

One competing approach to the Efficient Markets Hypothesis is the "Adaptive Markets Hypothesis," or AMH for short (a term coined by Andrew Lo at MIT). It says that inefficiencies like the ones above can exist, but that market participants search them out and eventually arbitrage them away until the profits from using these patterns get too small to be worth the effort. So, in essence, it says markets are efficient after all, but in an evolutionary sense.

I'm agnostic about which approach is correct. The AMH has a lot to recommend itself because (according to Grossman & Stiglitz) if there aren't some inefficiencies, there isn't any incentive for market players to gather information (which makes markets efficient). The G&S paper alkways troubled me, and the AMH provides a partial answer.

I just came across a great illustration (HT: Barry Ritholtz) that I'll use in class the next time I teach about market efficiency and "anomalies" like the value-glamour effect:
Scene One — Efficient Markets Hypothesis

An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Nonsense. If there were a twenty dollar bill on the street, someone would have picked it up already.” They walk past, and a little kid walking behind them pockets the bill.

Scene Two — Adaptive Markets Hypothesis, Part 1

An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. A little kid walking behind them runs in front of them, grabs the bill and pockets it.

Scene Three — Adaptive Markets Hypothesis, Part 2

An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says quietly, “Tsst. Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. He grabs the bill and pockets it. The little kid doesn’t notice.


Scene Four — Adaptive Markets Hypothesis, Part 3

An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He grabs the bill and pockets it. No one is the wiser.


Scene Five — Adaptive Markets Hypothesis, Part 4

An economics professor and a grad student are walking along the sidewalk, and the grad student is looking for a twenty dollar bill lying around. There aren’t any, but in the process of looking, he misses the point that the professor was trying to teach him. The professor makes a mental note to not take him on as a TA for the next semester. The little kid looks for the twenty dollar bill as well, but as he listens to the professor drone on decides not to take economics when he gets older.

Read the whole thing at The Aleph Blog. Once you read it, look around the blog a bit. Although the author (David Merkel) is relatively new with his blog, he's been in the finance game for a while, and his stuff seems to be right on target - it's interesting, technically correct and very well written. And not too many blogs pull off that combination.

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