The gift of market efficiency

The Dinosaur Question

Democracies are controlled by votes. All votes are equal. But, markets are not democracies. To understand the difference I’ll recount a lesson I was taught as a trader trainee back in 2000.

It was explained:

If you poll the population, “Did humans walk the earth at the same time as dinosaurs?”, the responses come back split about 50/50. That’s democracy.

Now imagine there is a contract that trades openly on an exchange that is worth $100 if it is true that dinosaurs and humans co-existed and $0 if that is false. Even though the population is split, this contract is not going to trade for $50. It’s going to zero. Why? Because the small percentage of people and scientists who know the truth are going to see a profit from selling this contract even down to $1 since they know this proposition is false. And if the scientists don’t have enough money, they will be able to convince or get hired by people with more money to back this venture of selling this contract to zero.

That is the value of markets. You get correct answers. While a democratic poll may tell you what people believe or desire, it does not assign the proper truth value to the proposition. Now consider the implications of being correct. You make more money which gives you more resources to continue being more correct. The marginal price in markets is set by the market participants with the most money and as a group, they have the best-calibrated assessment of what fair value is. And these groups are in the minority of the total betting population. Markets are not a democracy.

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Markets Are Not Democracies

Red Queen Of Alpha

The “red queen” is a reference to Lewis Carroll’s Through The Looking Glass. Alice had to run increasingly faster to keep pace with the queen. The feeling that you need to continuously increase your effort to maintain your relative position is a fitting metaphor for market competition.

In The Commoditization of Information, Geoff Yamane argues that an essential element of many businesses including investment management is a form of information arbitrage. Historically, information moved slowly, enabling savvy investors not only to find and synthesize the information but build a meaningful position to take advantage of it.

The internet massively accelerated the speed of dissemination and distribution of information, reducing the ability to extract economic rents from hoarded information.

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Many investors don't even need research to benefit from this informational efficiency: active management fees effectively subsidize passive investment products by ensuring information in stock markets is mostly well-priced.

Are markets efficient?

Academics will argue EMH ("efficient market hypothesis") with fanaticism. The sects are known as "strong form", "weak form", and the hardly-crusade-inspiring denomination "semi-strong". This is hardly the place for that discussion.

We can get more mileage out of simple induction.

In his book, Inadequate Equilibria, Eliezer Yudkowsky uncovers circumstances in which the prevailing equilibrium is efficient. When should defer to the wisdom of crowds versus dissent on the basis of your own judgments? What must be true for your own opinions to outperform consensus?

He asks:

Is there any other domain such that if we think we see an exploitable possibility, we should sooner doubt our own mental competence than trust the conclusion we reasoned our way to?

He has major doubts that the stock market is an "exploitable possibility".

If I had to name the single epistemic feat at which modern human civilization is most adequate, the peak of all human power of estimation, I would unhesitatingly reply, “Short-term relative pricing of liquid financial assets, like the price of S&P 500 stocks relative to other S&P 500 stocks over the next three months.” This is something into which human civilization puts an actual effort.

Typical arguments for market efficiency rely on empirical evidence to show that investor results are indistinguishable from monkeys throwing darts.

Yudkowsky summarizes the equilibrium by induction:

Millions of dollars are offered to smart, conscientious people with physics PhDs to induce them to enter the field.

These people are then offered huge additional payouts conditional on actual performance—especially outperformance relative to a baseline.

Large corporations form to specialize in narrow aspects of price-tuning.

They have enormous computing clusters, vast historical datasets, and competent machine learning professionals.

They receive repeated news of success or failure in a fast feedback loop.

The knowledge aggregation mechanism—namely, prices that equilibrate supply and demand for the financial asset—has proven to work beautifully, and acts to sum up the wisdom of all those highly motivated actors.

An actor that spots a 1% systematic error in the aggregate estimate is rewarded with a billion dollars—in a process that also corrects the estimate.

Barriers to entry are not zero (you can’t get the loans to make a billion-dollar corrective trade), but there are thousands of diverse intelligent actors who are all individually allowed to spot errors, correct them, and be rewarded, with no central veto.

He articulates my stance better than I could:

In the thickly traded parts of the stock market, where the collective power of human civilization is truly at its strongest, I doff my hat, I put aside my pride and kneel in true humility to accept the market’s beliefs as though they were my own, knowing that any impulse I feel to second-guess and every independent thought I have to argue otherwise is nothing but my own folly. If my perceptions suggest an exploitable opportunity, then my perceptions are far more likely mistaken than the markets. That is what it feels like to look upon a civilization doing something adequately...This is certainly not perfect, but it is literally as good as it gets on modern-day Earth.

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To dismiss the wisdom of prices is an impressive act of arrogance.

Why is market efficiency a gift?

It may seem discouraging to learn that the market doesn't provide easy money. You may want to curse the idea of market efficiency. But do not despair. There are 2 reasons why it should comfort you.

Capital is efficiently allocated

Efficient and honest price signals are a societal good. Market distortions are truth distortions. We are all better off when the right answers are rewarded. If we place bets we find out about those mysterious dinosaurs faster.

You aren't missing out on anything

If playing the market was a consistent way to make money, people would skip medical school and take the fast track to a life of leisure. Not everyone, but certainly enough to eradicate the easy profits. Do not be distracted from what you love. You are not missing anything.

As you will discover in this wiki, market efficiency has remarkable implications for what we should focus on. And even better, what we should not focus on.

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Learn More

Dinosaur Markets (Moontower)

The No-Easy-Trade Principle (Moontower)

Investing Is Biology Not Physics (Moontower)

Free online copy of Inadequate Equilibria (Link)