An efficient market is like a traffic jam

According to the Efficient Market Hypothesis, an individual investor really shouldn’t be able to regularly and reliably beat the market rate of return by picking her own stocks.

A lot of people misinterpret what is meant by the efficient market hypothesis. They hear, I think, the word ‘efficient’ as a kind of normative valorization. They assume that people who use the term are really expressing an emotional sense that “markets are perfect and awesome.” Actually, the idea behind the efficient market hypothesis is that the market is like a traffic jam.

When you get stuck in a traffic jam, you usually feel like the lane immediately to your right or left is moving faster than you are. It’s tempting to try to quickly swerve into one of those lanes. But when you think about it more, you realize this might not be a good idea, and the other lane’s advantage is probably only temporary. After all, the traffic jam stretches miles and miles ahead of you. If that lane were really much faster than the other lanes for a long stretch, a lot of people ahead of you would have gotten wind of that idea, and turned into that lane themselves. That itself should have slowed, or already be slowing, that lane down, until the point where it’s going as slow as your lane. And, indeed, experience suggests that any one lane’s advantage in a traffic jam is transient.

This is analagous to the really basic, modest idea behind the oft-derided Efficient Markets Hypothesis.  If there were obvious, publicly available information that showed you could expect an above-market rate of return on any particular asset, other people would have, noting this, bid up the price of that asset until its expected return matched that of alternative assets. You can’t even beat the market with a semi-sophisticated prediction about the future (like, “This firm isn’t a big name yet, but it will has a large market share in China, and will do well in the future, as their economy moves from an investment-led to demand-based economy”) because everybody half-intelligent analyst also thinks that, and is pricing that into the firm’s value.

But then, there are people and trading strategies (surpassingly few, I should note), who do seem to beat the market to an extent that can’t be explained by chance. How can this be?

The ways in which you could beat the traffic parallel the ways in which you could beat the market.

(1) As we noted, no one lane is faster than the others for any long period of time. But some are faster temporarily. If you’re way more aggressive than everybody else, and have a car with a much better accelerator, you can move into each lane as soon as it starts to gain a temporary advantage, and, swerving back and forth like this, get ahead in little piecemeal jerks over time. (This strategy, of course, has a lot of downsides, like wasted gas.) This is sort of like high-frequency volatility trading. You could physically locate your firm super close to the NYSE, so you literally get information about price movements microseconds before others do, and use those to execute super short-term trades on that momentum. Each one will yield a small profit, but over time, like this, you can get ahead of the market. (The downside of this strategy, of course, is that transaction costs from making so many trades, like the wasted gas, could erase your gains.)

(2) You could simply drive in the breakdown lane, and pass everyone, and hope you don’t get pulled over. This is sort of like (1) breaking the law or (2) executing a really, really high-risk strategy. But if you ‘beat the market’ by bearing more risk, you’re not really beating the market — you’re just getting lucky this time, doing something that others could have done, but thought better of.

(3) You could call up your buddy who works as an EMT, and ask him to listen in on some calls to figure out what sort of accident caused the traffic jam. Was it on the left side or the right side of the road? This will give you an informational advantage over the other drivers around you, regarding which lanes will be closed off in the future, so you can get out of them now. This is like trading on insider information.

(4) You could notice some surprising difference, probably stemming from a glitch of human psychology, and take advantage of it. For example, humans are naturally trained to, when they are dissatisfied with the speed of traffic, look to leftmost, passing lanes. This might give people an ingrained psychological bias to overrate the speed advantage of the left lane. This would, if true, mean that the right lane would be the fastest over the long run. Or you could rely on some funny legal effect. Of course, once other people figure this fact out, the strategy will mostly stop working. This is like any number of strange trends in stock market history, like the “January effect” or the small-company advantage, which have largely faded over time.

***

The big difference between a traffic jam and financial markets is that financial markets are a multi-trillion dollar business. That’s a lot of money incentivizing a lot of really smart people to make sure they don’t let obvious profit opportunities escape their notice. So, no, you almost certainly can’t beat the market.

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3 thoughts on “An efficient market is like a traffic jam

  1. You come close to the most important idea, but never state it explicitly: the EMH is only *approximately* true, and we should expect it to stay that way. There’s a feedback loop that keeps a stable equilibrium.

    If the EMH is very untrue, then it becomes very easy to make money by successfully trading assets. However, successfully trading assets starts to make the EMH more and more true, reducing the usefulness (and salaries) of additional traders. Combine this concept with opportunity cost, and you have a complete model: some people who *could* help make the EMH more true choose to be engineers or doctors instead, because it’s better for them.

  2. Pingback: Here’s all the interesting stuff in Nate Silver’s The Signal and the Noise | This is your brain on economics

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