Against Efficient Market Theory

The debate continues between efficient market theorists and those who are less sure about market efficiency, between passive or index investors and active investors. It’s easy to find support for the efficient market/passive investing side. They now dominate the academic and financial media worlds. Here’s an interesting essay by someone who identifies himself as a former efficient market theorist but who now sees holes in the theory. The essay covers a lot of ground, including the importance of not altering your behavior based on the latest study or research.

I’ve learned to not be overly impressed with a single study or even a series of studies, no matter how credentialed the authors. The data can be tortured to confess to anything. You need to apply liberal doses of common sense—more when the claims are outlandish. A new theory has to be backed by many independent sources of data, ideally data the theory’s originators have never seen, and you need to really kick the tires of any assumptions it makes.

The best models or theories are the ones that best predict previously unseen data using the fewest and weakest assumptions possible. It’s the litmus test of whether you’ve struck truth: Can you rely on it to work in the future? If not, it’s useless; it’s a prettified story, nothing more. Risk manager Aaron Brown argues many finance academics would never bet money on their more arcane models—such models are optimized for publication, to show how clever you are, not optimized to say something true about the world. The arguments put forth in high finance can have an otherworldly quality. Consider the closed-end fund “puzzle,” the fact that some investors buy CEFs at big premiums in initial public offerings, despite the sad reality that the premium almost always collapses within a couple of months into a discount. Prominent researchers have published papers with models and supporting data showing why such behavior is rational; common sense says IPOs are foisted on naïve investors. Unless you’ve overdosed on math, it’s clear which is probably right.