The Efficient Markets Hypothesis is pretty much indefensible. It is based on ridiculous assumptions: all investors have access to money at the same interest rate, have the same information and interpret information in the same way. It also has counterfactual implications: according to the EMH, markets would stay in equilibrium and move only when new information became available (which they don’t); people would not consistently outperform the market (which they do); and in its strongest form, it actually implies that bubbles can’t exist. The only defence its proponents seem to be able to muster is that it can’t predict anything (and sometimes, that economists full stop can’t predict anything). I could go on, and have, as have others. But what’s more important is exploring the many available alternative theories of finance. This is the purpose of chapter 15 of Steve Keen’s Debunking Economics. Keen goes through and assesses the major alternatives to the EMH on by one.
First, Keen mentions the obvious choice: behavioural finance. But he doesn’t really explore all the different heuristics and biases that people experience in financial markets – that would and has taken entire books. Instead, he objects to the way that EMH proponents initially defined ‘rationality.’ Apart from basically meaning prophetic, it was based on a misreading of John von Neumann, the creator of Game Theory, who said that his definition of rational would only apply when games were repeated enough times. A game with an unlikely but large loss as one of the possible outcomes looks less appealing when you do it once than if you play it 1000 times, allowing the losses and gains to even out.
Hence, Keen touches on something that others have mentioned: the whole idea that behaviour is either ‘rational’ or ‘irrational’ is not a useful way to think about human behaviour. In fact, behavioural finance retains some unfortunate implications carried over from economics: that we need to reduce everything down to individuals making choices, and that if only people behaved how economists think they should, then financial markets would be efficient. Having said that, behavioural finance is promising and useful field, though so far it is still in its early stages with no clear forerunning theories.
There are, however, a few theories which have been fully developed, and look incredibly interesting. The additional bonus is that they are complementary to each other (and to behavioural finance).
A fractal is a pattern that looks the same no matter how much you zoom in or out (see above). So it’s no surprises that one of the implications of the fractal markets hypothesis is that markets display similar patterns of behaviour over a day, month, business cycle or what have you. The fractal markets hypothesis models price movements as a function of previous price movements, which explains the emergent fractal pattern, and also means that stock markets will exhibit a tendency for volatility to produce more volatility, something contrary to the EMH.
A skeptical reader might suggest that this implies future price movements are easy to predict, if only one had the relevant formulas. But a system as complex as this would be highly dependent on initial conditions: just a tiny error in the initial values would soon produce results that were wildly offbase. This is what happens with weather models, and is why weather predictions are more likely to be right the closer you are to the day. It is actually probable that calculating prices accurately ould be computationally impossible using a fractal model.
But this might beg another question: why is the stock market not more chaotic? This is explained by dropping one of the assumptions of the EMH: that investors trade with identical time horizons. Similarly to von Neumann’s observations, a trade that looks bad for a day trader due to large potential losses at any one time, could look good for a long term trader if it has net positive yields over a given period. Hence, introducing heterogeneity makes the model more realistic. A highly promising theory.
The Inefficient Markets Hypothesis (IMH)
Provocatively named by its originator Bob Haugen, who has written three books full of data contrary to the EMH. The IMH suggests that markets systemically overreact to price movements, and hence cause incredibly inefficient allocations of resources.
Haugen identified three sources of price movements: event-driven, error driven and price driven. The EMH assumes away the second two, but Haugen has calculated that the third one accounts for up to 95% of stock market volatility, because price movements create a self-perpetuating spiral as investors seek gains or cut losses. Haugen has concluded that the stock market in its current form is a serious drag on investment, and suggested reducing the length of the trading day or simply having one auction per day.
Physicists have recently turned their hand to economics, and, due their strong empirical bent and the relative lack of data in economics, have been drawn to finance, where streams of data are readily available. Keen comments that much of Econophysics would perhaps be better named ‘Finaphysics.’
There has been a plethora of suggested approaches from the physicists, mostly applying their various chaotic theories to economics: earthquake models, power laws, the Fokker-Planck model. Keen does not go into much detail here because, again, it would take an entire book. He briefly goes over Didier Sornette’s earthquake model, which has been used to make explicit predictions about the future of stock markets. Keen directs the reader to this website, which supposedly tracks its predictions, though I cannot find anything after a quick look.
So there are many alternatives to the EMH, and each involve making explicit predictions and drawing on data, rather than handwaving ‘the market is volatile we can’t do anything about it’ statements. Personally, I consider the fractal markets hypothesis the most promising framework, and it is also one that can easily incorporate elements from the other approaches. I look forward to future developments in all of thee theories.