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Wednesday, November 8, 2017

Defining Market Efficiency Properly

The concept of market efficiency has attracted a considerable amount of debate over the decades. The issue is that the definition is problematic; efficiency is more an attribute of the investors in the market, rather than the market itself. If we turn the focus to the role of investors, most of the mysteries associated with the concept evaporate.

(Note: This article is in a preliminary state. I started thinking about how to write up the role of market efficiency in the context of breakeven inflation rates. I realised that I was unhappy with the existing definitions used, and this article represents my initial thoughts on the matter. It is quite possible that I will again revise my thinking.)

Efficiency is not an Absolute Concept

The idea of efficiency has considerable moral overtones in economics: saying something is efficient is the same as saying that something is good. I have an engineering background – where efficiency is a well-defined concept – and I was always skeptical about those normative associations with the term.

One thing to keep in mind is that efficiency is not an absolute concept, it is only defined relative to some context. For example, we could have a highly efficient natural gas furnace, where the efficiency is measured a percentage of the heat energy which is not lost for the purposes of heating the home. Meanwhile, we can have a step-down transformer that is highly efficient in converting high voltage from the power lines to the household-rated voltage level, where the efficiency is measured in terms of how little power is dissipated in the transformer. However, the furnace is not going to be a very efficient transformer, or vice-versa.

We need to think about what we are trying to do. In the case of investments, it is easier to think of inefficiency, rather than efficiency. Very simply, an inefficient investor is an investor that fails to take advantage of an investing strategy that offers abnormally high returns over relatively short investing horizons, and those returns are reliably realised. (Please note that the previous definition deliberately used vague wording; I expand it later.)

In other words, the investor is not taking advantage of strategies that will make them a lot of money. Knowing what we know about investor psychology, there is not a lot of institutional investors in that boat.

What happens if all investors are “efficient” (actually, not inefficient) by this definition? Well, it implies that there are no get-rich-quick schemes lying around for investors to take advantage of. This is equivalent to the common interpretation of market efficiency by market professionals: it is difficult to meaningfully outperform.

Conversely, if we say “the market" is efficient, what exactly is the objective “the market" is attempting to achieve? Without such an objective, we can hardly say that it is efficiently meeting goals. We do not have this problem when speaking about investors; we politely assume that they are attempting to maximise the returns on their assets. (This would not apply to ponzi schemes, of course.)

The advantage of this definition is that we are explicitly taking into account the institutional structure of investors, and this explains a lot of the supposed mysteries about market efficiency.

The Definition Depends on the Context

The terminology I used was deliberately vague, as it depends on the context. “Short-term” could mean one day for some investors (or even millisecond), but I would use one- to three months as the horizon I am thinking of. “Abnormally high returns” in the current developed market context would be 1% per month, but it would be much higher back in the day when Treasury bill yields were 12%.

Furthermore, the definition of “investors” I am using has some fine print attached to it. I exclude entities that are running a business for which the actual security investments are just a sideline.
  • Market makers at investment dealers should expect to generate a high return on equity (or else expect to be looking for new employment). However, those market makers are just the endpoint of an infrastructure that was developed to give them a flow of orders and information. The business of the investing firm is to make money off of the flows; in an ideal world, positions are flat at the end of the day.
  • Big commodity traders own infrastructure, and broker flows from producers to consumers. They should be able to generate a higher return on equity than punters gambling on commodity futures.
  • Warren Buffet is not just a stock picker; he is the head of business that buys and sells stakes in firms where he has an effect on strategy. Meanwhile, his insurance business has the famous float that is used to finance positions.
The term “reliable” used in the definition implies that the probability of outperformance is high, and the strategy is not expected to blow sky high if there are problems. Examples of “unreliable” strategies include:
  • Risk assets like high-yield bonds, equities, or even Treasury bonds may be expected to outperform cash on a multi-decade horizon, but there is a high chance of losses in the near term.
  • It is possible to earn a slightly higher return investing in risky commercial paper than Treasury bills. However, in order to generate outsized returns on equity (10% per annum, say), considerable leverage would be needed. You are one financial crisis away from having that strategy blow up.
  • Selling short-dated options tends to make money in the long run, but it can also blow up in a financial crisis.
Another nuance I have in mind (although not obvious from my current phrasing) is that this concept is tied to investing strategies, and not the market pricing at all times. It was possible to find a great many great trades in the depths of the financial crisis, but such anomalies were not repeatable. (Furthermore, almost no investors were able to take advantage of them, which underlines that the investors drive the concept of efficiency, not markets in the abstract).

Also, by focusing on strategies, we can end up in a situation where the same market appears to be both efficient and inefficient. Based on my reading of market lore, that was the situation in the 1980s in fixed income. Old school investors attempted to guess the direction of interest rates, with not particularly impressive results (that is, the market appears efficient). However, relative value investors made a fortune taking advantage of the mispricings generated by old school investors (that is, the markets were inefficient). Therefore, whether you think a market is “efficiently priced” depends on whether you have a trading strategy that can exploit mispricings.

Does not imply Forecasting Perfection

It is rather obvious that an investor who can accurately predict short-term market movements reliably would end up being extremely rich. Since we do not see a lot of evidence of such individuals in the real world, we can probably assume that having perfect forecasting abilities is not an option as strategy for investors. Therefore, one should not expect that forward pricing should predict actual outturns; all we can hope is that the forwards should not be so far off reality that we can reliably make money off them consistently in the short-term.

Concluding Remarks

By  the focus to investors, rather than some abstract concept of the market, we have a much more concrete understanding what market efficiency really implies. As I turn to writing about this in my breakeven inflation analysis book, I may return to this topic.

(c) Brian Romanchuk 2017


  1. In Thermodynamics the products of a process (that consumes a scarce energy resource or that convert natural power flows to human ends) are recognized as heat and work. Heat is sometimes valuable and work is always valuable so the concept of efficiency relates to how much heat is wasted or dissipated to the environment as an unwanted by-product. This does not encompass the human value judgments concerning what activities are a proper or valid use of energy, conversion of power, and heat dissipation compared to a different disposition of the same scarce resources. Ownership is the legal right to dispose of resources without answering to society (i.e., you don't need to ask anyone for permission or its better to ask forgiveness then ask permission).

    The efficient market hypothesis (EMH) in Modern Finance Theory seems to be different from the concepts of efficiency developed in law and economics. The EMH is usually used to argue that one cannot outperform the market in the long run in a competitive or highly efficient market so it is better to index-invest or develop a strategy that more or less accepts the market rate of return. In law and economics efficiency means an effort to optimize individual preferences in a social context.

  2. Do a keyword search "Fama video efficient market hypothesis" for some links to videos discussing this theory which seems to be related to your thoughts in this post.

    The link below contains several definitions taken from literature:

    Fama (Sep.–Oct. 1965: ‘Random walks in stock market prices’):
    ‘An “efficient” market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.’

    Two recognized criticisms are joint hypothesis and impossibility:

    Steven W. Smith provides a coherent model of cognition called the Information-Limited Subreality where the mind (or body-mind if one agrees with the teachings attributed to Buddha) is a Subreality Generating Machine:

    Each investor acts with uncertainty from cognitive models that can be characterized as an information-limited subreality. Some investors have access to superior information and have developed superior models of the social dynamics compared to other investors and have developed superior abilities to act on an effective profit strategy. In aggregate there are profits which some attribute to inefficient markets but Karl Marx and other smart guys recognized the expansion of finance makes profits flow onto aggregate balance sheets via the income statement. In other words the expansion of debt generates profits and inflates assets and equity values.

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