Mainstream financial academia regularly seeks to impress upon investors the supposed pointlessness of any entrepreneurial effort on their part, under the guise of cost efficiency and risk reduction. Besides misleading empirical evidence, the core argument used to justify the selection of highly passive and diversified financial products is the neoclassical efficient market hypothesis (EMH). Yet the EMH has suffered continual reputational blows, and the Austrian School’s causal-realism is well suited to disassemble it as another example of neoclassical physics envy.
Efficient Market Hypothesis
The EMH asks us to accept the following assumptions:
- All investors interpret information identically, with the same expectations concerning future conditions;
- Investors are perfectly “rational” in the aggregate, in that they are profit-maximizing and that, on average, they perfectly assess the impact of new information;
- The probabilities of all possible future conditions are thus known and imputed into prices;
- Prices are instantaneously adjusted by investors in response to new information and they follow an entirely random walk;
- All information is freely and equally available to all investors at no cost;
- Transactions are equally free and costless, and there are no frictions or taxes;
- Any and all arbitrage opportunities are instantly corrected
The implications of such assumptions would be profound if accepted.
Asset prices would be continuously trading at a perfectly-established fair value, and no consistent over/under/mis-pricing would arise for keen investors to exploit. Profits would simply be random occurrences, statistical reflections of equally random losses scattered around a “true” value.
Future returns would be completely unpredictable, as they would be solely based on currently unknown information and events arising randomly. No previous patterns, underlying information or insider knowledge would yield any speculative advantage, depending on how strictly we accept the assumptions (the EMH’s infamous weak/semi-strong/strong forms).
Any return would be entirely determined by the degree of “risk” undertaken, not by any distinct entrepreneurial foresight. The EMH’s investment recommendations would thus be to maximize one’s diversification in perfect congruence with the market’s composition of assets (the “market” portfolio) and avoid any attempts to outperform its weighted average (the “market’s”) return.
Epistemological Flaws
The EMH undeniably succumbs to both Occam’s razor and the Nirvana Fallacy, as none of its assumptions are applicable in the realm of human action, in which time, frictions, costs, and asymmetries are irretractable components.
The EMH ultimately fails to act as a proper hypothesis, and would be more aptly labeled a conjecture or tautology: its implications are tenuously correct within its own contrived conditions, but as it fails to take the form of an “if-then” statement and its conclusions concerning the “correctness of prices” cannot be empirically or logically tested, it is irrelevant as a hypothesis.
During attempts to empirically test the EMH, no effort is made to measure the “informational efficiency” or “accuracy” of prices, but rather the ability of investors to consistently earn “abnormal” returns (returns above those predicted by models which treat returns as mechanical compensation for certain “amounts” of risk).
This wayward turn gives rise to the infamous joint-hypothesis problem, in which abnormal profits can simply be dismissed as the result of an incorrectly-selected benchmark, completing the EMH’s journey towards an intellectual dead end.
A number of self-contradictions also arise within its assumptions: If all investors believed the EMH, none would make any effort to obtain new information and “correct” prices (given the pointlessness of such an endeavor), and prices would thus cease to be “correct,” violating the EMH.
Similarly, the EMH assumes all investors to be perfectly rational (albeit very robotically) and concludes that active investment is irrational. Yet while investors would be required to act upon information in order to “correct” prices, said action (and by consequence, the “efficiency of markets” implied by the EMH) would itself be irrational, fatally breaking the EMH’s internal logic.
While opponents of the Austrian School would obviously disagree, its flagship arguments, such as Austrian Business Cycle Theory, provide numerous examples of entirely expected and publicly-announced events creating distortions which nonetheless cause prices to change.
It is comical to witness neoclassical economists emphasize economic “free-riding” as one of the primary examples of market failure, only to advocate as an ideal the complete free-riding investment strategy in its perfectly efficient model of a market economy.
Information
One of the EMH’s most egregious fallacies is its treatment of knowledge as a monolithic good aggregately “possessed” by investors as opposed to highly tacit and intricately dispersed among individuals. Investment decisions take place precisely because investors’ expectations are not homogenous (i.e., they disagree about the value of an asset). If they all held the same subjective valuations, no trade would occur below, at or above said value.
For an active market participant, prices are by necessity “informationally inefficient” relative to their own appraisal of an asset’s price, which motivates them to undertake a trade. To the external observer, on the other hand, asset prices act as summaries of traders’ past subjective valuations, which they by necessity view as efficient, otherwise they would seek to correct them through trading. Most importantly, differences in individuals’ understanding and interpretation is perhaps the most fundamental factor motivating human communication: that individuals communicate between each other at all invalidates the assumption of homogenous expectations.
Limits to the Imputation of Information
Even if we ignore such heterogeneity, exactly how “far” could information be perfectly and immediately priced into asset prices? The causal chain of economic activity is incalculably long and complex: To argue that all future consequences implied by a “piece” of information can be perfectly, instantaneously, and costlessly interpreted by investors borders on the absurd.
In addition, investors do not unabashedly dedicate the entirety of their capital to the imputation of some piece of information, but rather do so proportionally on the basis of subjective conviction. The instantaneous and perfect imputation of all information across all markets is rendered simply impossible by the scarcity of capital and the sheer number of tangible frictions, costs, taxes, and regulations.
To treat information itself as costless also ignores the continuous competition between entrepreneurs for more efficient and accurate information, and the restrictive costs associated with such a contest for a comparative informational advantage.
Uncertainty
In order to maintain the model’s consistency, the EMH bizarrely assumes both the complete unpredictability of future events and the aggregate market’s perfect estimation of the probabilities of all future conditions. If all possible future conditions simply corresponded to a knowable probability distribution, any new information would be valueless, prices would be irrelevant in their role as information, and economic calculation using prices (along with the use of money itself) would become entirely unnecessary.
The acquisition and application of knowledge is purposeful as opposed to random, undermining the assumption that resulting price changes are entirely random phenomena. Information in the economic sense exists and is valuable because the future is uncertain and does not conform to knowable probabilities.
Much of the “information” concerning the factors which influence an investment’s valuation is available yet not precisely knowable, such as consumer preferences or entrepreneurial innovation. Furthermore, the act of investment is often speculation concerning both unavailable and unknown future conditions, not a probabilistic imputation of “existing” information into prices.
While the technical analysis of historical price patterns is the principal target of the EMH, economic activity is shaped through learning from past information, and thus past prices undeniably serve to influence future prices, discrediting their treatment as random.
Profits
Far from anomalistic or random, profits, errors, losses, and “mispricing” all play key roles in a market economy as signals and incentives for continuously self-correcting entrepreneurship. Entrepreneurial speculation ultimately guides all investment: profits result from the correction and (re)alignment of the prices of the factors of production with consumer preferences, while the rate of profit corresponds to the degree of said aligned discrepancy.
Profit is not a mechanical compensation for some quantitative metric of risk undertaken, as the constant occurrence of “abnormal returns” highlights. It is quite ironic that such risk-based models have a history of increasing systemic risks and result in absurdities such as recommendations in favor of negative-yielding assets in the name of diversification.
Conclusion
An uncertain world precludes profit opportunities, and as long as human beings are not perfectly omnipotent and their preferences continually evolve, the human experience will be one of uncertainty. Achieving consistent speculative profits is an arduous task, and the Austrian School’s axiomatic framework of competition and incentives provides applicable explanations for why that is the case.
The efficient market hypothesis, meanwhile, is yet another neoclassical equilibrium model whose relevance crumbles under the weight of its own unrealistic assumptions.
