The myth of an efficient market, part 2/3: Preconditions for efficiency

In the previous part I described how market efficiency has been generally defined, and how it in my opinion should be understood in practice. I also defined an example formula for calculating market efficiency as a percentage. But what would it require in practice to actually achieve perfect efficiency? For each security there should at all times be enough willing buyers and sellers with adequate purchasing power and an exactly correct and adequately strong view about the correct price of the particular security. In principle one party interested in selling and one party interested in buying may suffice. However in order to form that exactly correct view and to actually follow that view to an adequate extent several preconditions should be met.

1. Perfect information

In order for the market to function fully efficiently, there needs to be perfect information. At its narrowest, the public information mentioned in the depiction of Fama's semi-strong efficiency could be understood as including merely the economical figures of the stock. However the future and thus the price of the company can under no circumstances be deducted from just these figures. A company has a specific business branch and a specific position in its field. The clients also have certain economic power and motivation to buy the products or services of the company, and in addition the whole economical atmosphere in general needs to be taken into account. Thus it is clear that proper price formation demands extremely broad information about all these matters.

Since most of this data is actually not strictly numerical, I think there is no point in making any other artificial restrictions to what the needed information actually consists of either. Instead, all information that anyone with an access to the market anywhere around the world possesses, should be included in the price-forming process. Especially in the global market the amount of this kind of information is extremely vast. Part of this information is relatively easily available for anyone. Part of it on the other hand is knowledge that cannot directly be accessed even by company insiders, but which may be accessed by some party interested in investing, who can thus benefit from this information. This kind of information would be the economical or consumer atmosphere in a certain market area, or knowledge about some kind of a potential scientific breakthrough for example.

When information is thought on a large scale like this, also the so-called insider information is just a small summary of sorts or a peek into an ocean of information. In principle it hardly brings any extra information, but in practice it may be a conclusive factor in the humanly restricted decision making.

2. Perfect interpretation

Information in itself does not reflect any price, so also interpretation is needed for price formation. Thus, in order for the market to be fully efficient, the price has to be based on perfect interpretation as well. Just like the perfect information, also the perfect interpretation should be based on the best know-how that can be found in the world. This analysis would of course be an irrationally complicated process, which would include everything from microeconomy to macroeconomy, from predicting changes in the technological as well as the natural environment to predicting changes in the political decision making, population growth and social culture - along with of course assessing alternative investment possibilities and their relative profitability.

3. Sufficient time and motivation for collecting and interpreting the information

According to the efficient-market hypothesis, the efficiency should be there all the time no matter what the circumstances. Thus, when new information comes up, this should be instantly reflected in the price. This would mean that for example changes in currencies or raw materials prices should instantly be reflected to the whole market network through even the most indirect connections. In practice, even the collective intelligence of the world analysing such humongous networks of cause-and-effect might only succeed in a timespan of months or even years - and even then always imperfectly.

In addition to time, those who have the power to affect price formation should have enough motivation to study and analyse all relevant information. There is of course an inherent paradox related to this: there would never be adequate motivation, if the market would already price the security perfectly.

4. No affecting external economical factors

In addition to the abovementioned factors describing informational efficiency, there are also factors which should not disturb efficient price formation. There should under no circumstances be such external economical agents that would influence the core price formation. To elaborate, private investors in the core of the price formation should not have such strong and irrelevant motives that are based on economical pressure (eg. unemployment, disease, divorce) or need (eg. vacation, buying an appartment), or taxational factors, that they would make the price of the security sway from its true value.

The same of course applies to institutional investors, who actually have even stronger potential to shake up the price formation of securities. In a fully efficient market institutional investors would for example never make allocation changes in a way that would include ill-proportioned trades compared to the normal trading volumes of a specific stock. There should also be no asymmetrical bonus systems that give bonuses for extra profit but do not punish for losses to the same extent, since these kinds of moral hazards might cause an emphasis on the more risky securities.

5. No affecting psychological / speculative factors

Since the market basically consists of just people, one significant factor is market psychology, which directly affects the lowest level of efficiency, namely technical analysis or in other words predicting from past prices. This psychology has a few special features. In addition to the fact that people may predict the future of a company emotionally, people also speculate, what the others think about the future of a company. Moreover, people may also speculate, what the others might speculate. In the end some market movements may momentarily be based on mere speculation of speculation: no one believes that the real economy factor behind a movement would be as significant as the market reactions, but enough people believe that others believe in its adequate significance.

Another special feature is that even if a market reaction was not originally based on anything real, the psychology on the market may create a chain reaction that may have consequences in the real economy as well: once trust gets weaker, companies may invest less, which causes the trust to get even lower - and vice versa. As a result there may be strong overreactions in both directions, when fear or greed take over. However, true efficiency should be able to keep these feelings and overreactions at bay.

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The myth of an efficient market, part 1/3 - Definition of efficiency

According to the efficient-market hypothesis the prices of all traded assets always "fully reflect" all information related to them. The most essential direct implication of this is that no one can continuously outperform the market. However, hardly any one suggests that the market would be entirely efficient, although on the other hand utter ineffectiveness would be an even more impossible idea. It is also clear that not all markets or submarkets function with the same degree of effectiveness.

Nevertheless, I'm surprised how strong the belief in market effectiveness appears to be in the economic field. For example according to the view of a Finnish doctor in Science and economics, the market would be 95 per cent efficient (Meklari 1 / 2010 in Finnish). No matter how you define this percentage and regardless of whether you look at the market through the obvious theoretical preconditions of perfect effectiveness or through practical experience in history, I find it very hard to believe in an efficiency of this magnitude.

This is the first part in a three-part series of blog entries. In this part I will have a look at the definition of effectiveness, whereas the latter parts will concentrate on the theoretical preconditions of perfect effectiveness and the level of effectiveness encountered in actual stock markets.

The definition of an efficient market

Eugene Fama is perhaps the most well-known spokesman for market efficiency. In 1970 he defined three forms of efficiency. The weak form only suggests that you cannot predict future prices for a traded asset based on past prices - and thus technical analysis is a futility. According to the semi-strong form all public knowledge is reflected in the price, so there's no point performing fundamental analysis. The strong form asserts that even insider information is fully reflected in the price.

In my opinion it's misleading to even define the weak form as efficiency. In practice, it only tells whether investors groundlessly base their choices on something that others have done earlier. The fact is that the price history of a stock has nothing to do with how sensible or valuable a specific company is right now. Ignoring the historical prices is certainly a part of the efficiency as a whole, but in itself it only measures how common irrational decision making actually is - in other words it's more like a measure of ineffectiveness rather than effectiveness.

The strong form on the other hand is rather absurd to begin with: how could insider information be included in the price if the holders of that information cannot even utilize the information without breaking the law? And if the insider information would be thoroughly reflected in the market, it wouldn't be insider information any more, now would it? Thus it could be stated that the semi-strong form is most open to debate on actual efficiency. However, rather than looking at three different forms of efficiency, I think it is more sensible to think of these three forms as different layers of the overall efficiency - layers which can be evaluated separately from each other. For instance, one practical implication of this is that in principle the efficiency on the "semi-strong / fundamental layer" could actually be higher than the efficiency on the "weak / technical layer". The fundamental and insider layers could also be considered as one single layer of informational efficiency, whereas the weak/technical layer could also be seen as a psychological and speculative layer.

Whether efficiency is viewed as a whole or through its layers, it seems to me that there is a common fallacy in its definition. It is true that as a consequence of perfect efficiency no one could ever outperform the market without good luck. However, since people are deficient, this reasoning doesn't work the other way around. In other words I find it rather peculiar, if someone tries to prove market efficiency by showing how no-one or merely few can actually beat the market. It's peculiar because already those few are a sign of inefficiency. But more than that, it's peculiar, because prices that fully reflect all information can only mean that the price of a traded asset is always truly "right", and that this price would include all possible information about the state of the company and its future prospects in a perfectly interpreted fashion. It's no wonder that not even the most talented investors can fully define this price in order to benefit from it - not even if they would have a limitless amount of time and resources at their disposal.

In the introduction an efficiency percentage was mentioned, so a definition for calculating one is in order. So let's say there is a "correct/true" price for each stock. Let's also think of a stock exchange and assume that we would have the information about the "correct/true price" of all shares. Since we're talking about the efficiency of the market as a whole rather than just the index, every single share needs to be taken into account separately. The preciseness of the price of a stock could be defined directly as a ratio between its "true value" and its market value. In order to get this value between 0 and 100%, this ratio should be calculated comparing the smaller value to the bigger one. The overall efficiency of the market could then be for example a weighted average (eg. based on company market values) of all stocks. As a formula this would look like as follows:

, where E is the Effectiveness as a whole, n is the number of stocks, w the entire market value of a company, and the letters v represent the "true" (t) and market-based (m) values of a single share.

The true value required here is in practice of course not explicitly definable. However, compared to the time when the market value was defined on the stock exchange, it still should be easier years afterwards. In this case there might of course be a tendency to hindsight bias, where this true value was based on something that could never have been predictable earlier. However, there are still many things that can be fairly judged in retrospect as something that could have been predicted, as long as those who were in the market would have just looked close enough and interpreted the information in the right manner.

In my opinion, when one considers a subject as theoretical as market efficiency, it cannot be justified by just assessing the performance of invidual people. Otherwise you could as easily state that no mammal can run 100 km/h, since no man is capable of that; or that a neighbouring galaxy does not exist, since man can't reach that. In other words, even though a person was not able to define the true price of a share let alone do that in adequate time to actually benefit from it, it does not mean that this true price didn't exist. After all, practical markets are only a manifestation of the inefficient decision-making of people who work under economical and even social restrictions, affected by irrational emotions, with limited information, limited time and limited comprehension in terms of actually interpreting the data at hand. Accordingly it is only natural that the stock prices are also defined at least somewhat inefficiently.

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Beach resort rules

In general, I'm not particularly interested in sheer beach resorts, where the most essential activity seems to be lying in the sun and barbecuing oneself - or more nastily put, purposefully making your skin look older and increasing the risk for skin cancer. Nevertheless I'm not entirely against beach life, so in case a specific resort offers something else too, a beach and/or pool are certainly a welcome addition.

However, even with my limited experience on beach resorts, I've still come under the impression that many of them have a rather peculiar practice: since the amount of deckchairs is limited, people wake up early in the morning, pick up towels from the hotel and use them to reserve deckchairs from the beach or the pool, after which they go back to sleep, to have breakfast or to do both. This doesn't make much sense now, does it?

In terms of the enjoyability of a resort in general, this isn't very fruitful: the deckchairs may stand there empty, even though there would be people interested in taking them, and on the other hand the abusers of the system have to wake up earlier than they otherwise would. Wouldn't it be better if the beach would have a guideline like this or something similar:

"Deckchairs cannot be reserved with mere towels or other personal belongings for a time period longer than the duration of a swim."

Based on this, deckchairs having just towels and no-one around could be easily claimed and the actual utilization rate for the decks would be improved.

Despite its simplicity and low meaningfulness, this small problem can actually be seen as analogous with bigger issues in bigger communities, namely societies: some may claim the right for certain commodities or assets, even though it would be more beneficial to others.

In case some one with experience on beach resort deckchair reserving policies ends up reading this blog, I would appreciate any comments on the subject.

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Stability vs. moral hazard - a compromise to deposit insurance

When the Icelandic banks started persuading clients from the UK and the Netherlands with high interest savings accounts, those interested in the offer could be roughly divided into three groups. Some merely saw the interest, and did not think there would be any risk involved. Others predicted that the Icelandic economy would end up in a serious crisis, and thus stayed away. And then there were those, who had a hunch of the emerging problems, but an even stronger confidence that in case of a crisis, deposit insurance would cover the losses - as it did in 2008.

The deposit insurance is not only an important security factor for individuals, it's also an essential element in maintaining the stability of the economic system. Its downside on the other hand is the moral hazard residing in the minds of the aforementioned third group : potential profits are taken to oneself, whereas the risk is socialized to be paid by others. In this sense deposit insurance has a lot in common with the current Greek bailout. Both basically boil down to a conflict between maintaining stability and avoiding moral hazards. The first one (stability) is of course more important, but ignoring the latter entirely may ultimately result in losing the first one too. And it seems to me that moral hazards aren't payed enough attention to.

In case of deposit insurance, perhaps an efficient balance between stability and moral hazards would be to make the deposit insurance reversely progressive. As a simple example, the savings could be fully covered till 20 000 €, 98% covered for the amount of money exceeding 20 000 €, and 95% covered for the amount exceeding 50 000 € up to 100 000 €. Thus, the most basic savings would be fully protected, but with deposits resembling investments, part of the risk would be taken by the depositor. The risk would remain so small that it would not cause a large scale panic on the market.

Another interesting factor is that apparently the promised interests are also a part of the deposit insurance. As a matter of fact, even now and still for about month now, a few thousand clients of the Finnish Sofia Bank are waiting the last 15% of their money - and with interest. By restricting the amount of interest paid in case a bank ends up in receivership and/or by perhaps implementing a reversely progressive deposit insurance, the moral hazard could be avoided. With a model like this there could have been a bit fewer Icesave savings in the Icelandic Landsbanki, which in turn could have made the economic bubble in Iceland at least a tiny bit smaller.

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Greece and bankers should take their responsibility

Greece has agreed to accept the bailout terms. In other words, it accepts taking the helping hand. It is a little bit peculiar to think that the whole process could have been depending on Greece's approval. It is obvious that with or without a bailout, the crisis will have a serious effect on the lives of ordinary Greeks. Yet based on common sense, one would think that the bailout would make the bumpy road of the upcoming years at least a bit more pleasant. So why shouldn't Greece accept the terms? However, the other countries in the eurozone would have at least two reasons not to...

1. Greece has enough assets to pay the debt off?

The first, yet perhaps less significant reason not to support Greece is partially moral. Why should we support a country, who cheated its way in joining the EMU? Or should we support their ridiculously low average 53 year retirement ages? Or the pensions that the civil servants' daughters are allowed to collect - civil servants who themselves practically can never be fired? Other curiosities like the bonus for arriving to work on time, 14 month annual salaries or the computer usage bonus basically remind me of the rather silly looking evzones of the presidential guard (on the right): is this the kind of circus other eurozone countries are financing?

Of course the most obscure practices in the Greek economy will most certainly be dealt through the terms of the bailout. And the crisis could have been mostly avoided, with a tighter control on Greece joining the euro or preventing it from getting into this much debt. But now this is the situation we have to deal with, so the question remains: should Greece have a greater responsibility for the problems that it has caused by itself? Although control will probably be tightened due to these experiences, the bailout gives an unconstructive message: if we end up in serious trouble, the others will help - so why not continue our irresponsible economy?

If a country didn't have any possibility to deal with its debt, then forcing more responsibility isn't really an option. However, is this really the case with Greece? According to Financial Times, Greece has properties of over 300 billion euro. If this is true, from what I've understood, this is relatively unmatched in most western countries. Iceland has endured significant losses when Icelanders have had to sell their possessions at low prices due to their crisis. Why shouldn't Greece also need to sell some of its possessions - especially if it really has the assets to do so? Couldn't this be a part of the bailout terms?

2. The bailout is supporting the banks

Another factor is that the bailout is basically supporting the creditors, who took a risk when loaning money to Greece. Biggest of the creditors are German and French banks. From what I've understood they might be the biggest creditors even in comparison to the size of the German and French economies, which would mean that Germany and France benefit the most from the bailout. Can this be right? There are also other creditors, some of which are even outside the eurozone. Do we also want to support them?

The purpose here is of course maintaining economic stability and credibility. But couldn't it be done without giving out the message that banks are free to take risks for profits, but the bigger losses will be socialized anyway? Couldn't the debts be organized in such a fashion that the eurozone countries would get shares of the banks that they are basically supporting? Thus, the current owners would have to face the realized risks, but the economic system would be left almost unharmed.

=> Co-responsibility?

Grasping the entirety of the situation, and evaluating the possible scenarios caused by various courses of action, is of course very difficult. The motivation for the bailout is not saving Greece per se, but maintaining economic stability. However, for the aforementioned reasons the current bailout seems morally wrong and transmitting all the wrong messages. Why should the eurozone pay for the mistakes of Greece and the banks that gave Greece loans? Shouldn't at least part of the liability be pushed to that direction? If Greece would sell its possessions for the worth of even 50 billion, and euro countries would receive shares from the banks they are basically financing, the whole crisis would be a far better lesson in economic morals.

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Expo 2010 - roadmap to a Chinese future

The next world's fair, Expo 2010, will be held in Shanghai, China. It will begin in less than two weeks, starting on May 1st and continuing till the end of October. The area of the Expo will be the largest in the history of world's fairs and it is also expected to reach the largest visitor count in history - a goal I believe it will easily achieve. I also believe it will do more, by exceeding its goal of getting 70 million visitors. However, it can be seen as more than just a hugely popular event.

So far, due to its huge size, China has been a prime example of a country to which western corporations have moved their manufacturing in order to save money in labour costs. This, sometimes referred to as the "China phenomenon", has been a significant factor in China's economic rise and has pushed China towards a more consumerist lifestyle - especially amidst the younger generations. In addition to being a growing market and a place for manufacturing, an emerging trend in the upcoming years will be the increasing amount of also white-collar work moving to China. One factor supporting this is the increasing amount of Chinese with a sufficient knowledge of English or other foreign languages. This in turn will further strengthen the Chinese influence over the world.

All of this has made the Chinese economy growing at a very rapid annual rate of about 10% during the past few decades. It is almost inevitable that it will, at some point, surpass the U.S. as the biggest economy on the planet. It may be unlikely that it would happen as soon as during this decade, but even so, it probably will happen during the 2020's. As a consequence not only is the Expo 2010 a huge event, but it can be seen as a sign of what is to come. Just like the expo held in Shanghai will most likely be the biggest of its kind so far, so will China very likely soon be the most powerful country in the world - at least in the economic sense. Therefore, when looked from the late 21st century, this year's Expo might be regarded as a harbinger of a new era.

What kind of consequences this power shift to the east will have remains to be seen. It is to be hoped for that issues related to human rights, corruption and freedom of speech will be improved by the time China reaches the status of the biggest economy in the world. At that point the importance of China as a market will be bigger than ever, and this will most certainly affect the way China views the rest of the world. As staying in China will become even more important to most multinational corporations, China has little need to specifically persuade any company or to try to please western organizations. Thus, the drive for change has to come from China itself.

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Life in a complete world

We are living in a constantly changing world. Technological progress is continuously changing our every day lives, world population is still strongly growing, fossil fuels are being depleted, the power balance between countries is changing, countries split, international collaborative organizations are established and expanded, demographics are changing due to immigration among other things, man is shaping nature and environment, languages die and globalization unifies cultures.

What if we would live in a world, where all this was no longer true? Technological progress would have practically reached its peak. Population growth would have stopped and would be controlled for example through jurisdiction if needed. The social structure of the population and the possibly still existing countries would have been stabilized. Fossil fuels would have long ago been completely or almost completely replaced by alternative energy sources, and the human relation with nature would also otherwise be in balance. Real economic growth would have stopped and the division of wealth would be stabilized. Everyone on earth would either have the same mother tongue or at least the amount of languages and their power relationship would not change.

None of these are close, but the idea is not impossible in the very long run. It may also be that the pace of change is currently at its highest, and in the upcoming decades life will change slower. At least so far the most rapid technological revolution in the entire history might have been the way mobile phones and internet have conquered the world during the last two decades. In practice, we are currently just adapting to the effects of this revolution – both on individual and societal levels.

Then what would it be like to live in a truly complete world? The world would probably be, if not entirely equal, a lot more equal than it is today. There would be no war-torn countries nor significant violent conflicts between cultures. In addition to an abolished global inequality, there would also be no inequality between generations: no real economic growth and no new technologies or technological applications would emerge to make life easier. There would also be very little if any reason to fear population growth, global warming, great wars or technological progress potentially going too far.

Apart from the positive factors like equality and safety, also downsides can be seen. From the perspective of the contemporary man a future without linguistic or cultural diversity might seem like a depressing scenario. On the other hand would one be able to miss something that one has never experienced? Some probably would miss, but most perhaps would not – at least not on a substantial or conscious level.

How about what life in general would feel like, if the world would have been approximately the same for centuries, and there would be no reason to assume that the following centuries would in any way differ from this? Would it result in a lack of objective and healthy ambition? In science there would be no new discoveries to be found. No industry or profession would be facing any kinds of changes. Of course this would result in a general feeling of safety, but perhaps also a feeling of purposelessness. No new ideas would be brought up in any area of life – not in technology, literature, art, pastime nor in social relations.

Also in the entertainment culture practically everything would have been experienced. In movies and games or their future equivalents all the stories and phenomena would have been seen. Since similar entertainment - both technologically and in terms of content - would have been produced for centuries and all the old production would be easily available, entertainment consumption would most likely be far more fragmented than it is today. Both in entertainment and in fashion there could of course be short-term variation, but in practice everything would be repetition of something old. Everything would have been already experienced. But although we would have reached our final goal as a race, there still might be space for individual dreams and goals.

A lot of people may consider a utopia like this rather impossible. Maybe it is, maybe not, which is of course largely dependent on how tightly the term “complete” is defined in this context. In any case, in spite of its perks, the state of goallessness, that is an inherent part of a complete world, might not be entirely worth striving for – although there would perhaps be even less sense in trying to purposefully avoid it. Either way, the current speed of change and progress does not always feel right to the human nature. The older one gets, the more exhausting the surrounding invisible turmoil may feel.

For the time being the train of progress is continuing its journey at high speed. Each of us may decide for oneself, how perseveringly one is willing to chase it.

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