This means that market prices are predictable but only after the passage of 10 years of time or so.

I can ‘predict’ most things that happened in 1999 with relative accuracy.

In a market in which prices are set by emotion in the short term but by economic realities in the long run, investors should be changing their stock allocations in response to big price changes, not practicing Buy-and-Hold strategies.

That depends on your time horizon, doesn’t it?

EMH true believers think that the extra .2% per year we get is worth bank panics and depressions every 20 years.

Most non-autistic people think differently. They correctly note that in a world with lots of bank panics and depressions, they have good odds of losing everything because of somebody elses bad decisions. They correctly note that maximizing gains is not optimizing risk.

Even if the EMH was true – even if it was – using it as the exclusive guide in how to run the economy is stupid. We don’t want to maximize our wealth exclusively, we as a citizenry, like relative stability much more.

How much of your net worth would you give up to guarantee you would not lose the rest? Pure EMH people say “I would never take this option”, but most people would say something like 10%

We have laws and restrictions on every other area of complex human behavior. Would you really claim that we should abolish all stop lights and traffic laws?

You’ve seen this study right? It is a great asset allocation tool if you have long term time horizons

Then, how about all of the Haugen studies?

I mean, this isn’t even a contest. There are dozens of “anomalies” in stock markets – and this is the market that should be most “efficient”

Then there how about the famous noise trader study by Delong?

Some people call these anomalies, but I like to call them what they are – proof the EMH is BS and has always been BS.

You can lead a horse to water, but you can’t make him drink.

Its when you write down a theory of the stochastic discount factor — when you give a specific theory of how the market prices risk — that you *may* have to make assumptions about the distributions of returns. The CAPM does have these assumptions, but this is not the only risk model.

Brock and Lakonishok a long time ago showed that technical analysts can beat the market. Robin is right that it is unlikely that any regulatory body will be able to replicate this. However, there may well be good reasons for certain kinds of increased regulations, such as to either outlaw certain particularly dicey derivatives, or at least to force the markets to be more transparent and public.

TGGP,

Fama’s reply is disingenous. I have no idea what Fama has told his students, but one cannot find anything about fat tails in Cochrane’s book. If Fama spoke of fat tails, his students managed to completely forget it. His defense of “portfolio theory” as such is not of standard CAPM, but only of the most general sort of rule, such as a tradeoff between risk and return. Wow. It is also the case that Fama disagreed with Mandelbrot on some crucial points, such as that second moments vanish asymptotically, a key part of his argument for fat tails, although they can still arise if fourth moments do so, even if second moments do not.

What value does denying EMH have for people who want more regulation?

In other words, the real problem with EMH is the claim that people cannot systematically outperform the market because the market is so damn smart. People also couldn’t outperform the market if prices were determined by pulling numbers out of a hat. The Crazy Market Hypothesis, or the Largely Random Market Hypothesis, don’t square quite as well with good ol’ neoclassical econ, so they get rather short shrift.

Yale Professor Robert Shiller did this in 1981. He showed that through the entire history of the market stocks have generated better long-term returns starting from fair or low prices than they have starting from high prices. Valuations have always affected long-term returns. The market has never been efficient. At least not in the way that the conventional theory posits.

The confusion stems from the fact that the market must be efficient in the long run. The entire purpose of a market is to set prices properly. So there is a good deal of efficiency after 10 years and a high amount of efficiency after 15 years. Market prices are set by emotion in the short term and by economic realities in the long term.

This means that market prices are predictable but only after the passage of 10 years of time or so. It also means that the conventional investing advice of today (rooted in the old understanding that efficiency takes place immediately rather than only after a long passage of time) is the opposite of works. In a market in which prices are set by emotion in the short term but by economic realities in the long run, investors should be changing their stock allocations in response to big price changes, not practicing Buy-and-Hold strategies.

There is such a thing as market efficiency. But the old understanding is more wrong than right. The idea that investors don’t need to change their stock allocations in response to big changes in stock prices has caused the biggest loss of middle-class wealth in the history of the United States. So we do need to get that old understanding corrected. And policymakers should be encouraging investors to lower their stock allocations when prices get to insanely dangerous levels (rather than to buy stocks regardless of price, a “strategy” that benefits only The Stock Selling Industry).

Rob

Case in point let’s say I am selling a security that has a random payoff of $100 with 1/10 chance and $0 with 9/10 chance. Let’s also say this security is not correlated with any other asset price, so that all marginal buyers are risk neutral.

As long as the security is prices at $10 it is “efficient” but the returns to it certainly are not normally distributed.