Beating the Market – Updated

This week’s announcement of the Nobel Prize for Economic Science triggered a lot of fresh debate about market efficiency and whether it is possible to beat the market. I like this column by John Cassidy. He argues, I think correctly, that markets aren’t efficient. But here’s one point that I think many people miss. They conflate two separate issues. Whether or not markets are efficient is one issue. Whether or not an investor can “beat” the market is a separate issue. The second question also begs another question: Are the major stock market indexes “the market”? I don’t think so. I think they are fairly efficient and effective ways to invest in a particular asset class. In fact, I believe a number of the indexes and index funds that try to emulate them are good ways to “beat the market.” But that’s an argument for another day. For now, enjoy this discussion of market efficiency.

Part of the problem is how financial economists define efficiency. In most areas of economics, efficiency is defined in terms of how well markets allocate resources. If a given market allocates them in a way that leaves it impossible to increase the welfare of one person without lowering the welfare of at least one other person, the market is said to be “Pareto efficient.” One of the big achievements of twentieth-century economics was in showing how, under certain highly restrictive conditions, a free-market economy can produce a Pareto-efficient outcome.

Since the nineteen-sixties, when Fama got his start, financial market efficiency has been defined rather differently. According to Fama’s definition, which quickly became the standard one, a financial market is “weak-form efficient” if prices reflect all the past information that is relevant to the market, such as the history of price movements. The market is “semi-strong-form efficient” if it reflects all past and current public information. And it is “strong-form efficient” if it reflects all the public and private information.