17
Sep
2014
You’ve Heard of Moneyball…
…now get a load of the Efficient Majors Hypothesis, or EMH. A sample:
EUGENE: All right, it’s worth asking what those fees for active management have actually delivered to the investors. I ran a statistical analysis on the National League all the way back to 1876. Do you know that in every single season, when you rank the teams by their records, fully one-half of them fall below the median team? What the heck are these owners paying for?
It’s a satirical piece, of course, but by the end I had half-convinced myself.
I believe strong EMH could be true. Wouldn’t it be true in a perfectly competitive market?
Separately, it’s important to know that perfectly competitive markets are unattainable. Just because we can describe the Platonic ideal doesn’t mean that we should go looking for it in the real world, or despair when we can’t find it. Those who do cannot be taken seriously.
There’s a long and difficult discovery process. We can’t look into the future, and as Eugene points out, statistical noise is significant here. Thus, all the buyers and sellers in the market for managers (and also players for that matter) are operating with noisy incomplete information. Not much different to betting on horses, but that’s the general idea of what sport is all about.
I don’t have a strong position on EMH, though I must admit finding it appealing. Regarding discovery and noise, aren’t those all consistent with e.g. http://en.m.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street ? I still haven’t read it, though I think it’s on my Kindle.
I can definitely see Ricketts responding “the who-sa-what?” if someone had the temerity to use a big word in his presence.
That said, the jury definitely *is* still out on how much difference a manager actually makes — though not, of course, for EMH reasons.
I’m curious how much value managers actually provide. If a team were run by a program which made decisions in a mechanistic way following simple percentage based rules, it might actually outperform a human manager.
I love it! John B. I initially started this piece as satire, and (as I said in the OP) by the end I realized that some EMH people would be convinced. At least I didn’t suggest eating Irish children.
So I guess Billy Beane would be their Warren Buffet?
http://fivethirtyeight.com/features/billion-dollar-billy-beane/
Baseball is played by the players. Every “great” manager had great players and a lot of research suggests that simple rules in finance and business, like credit scores for home loans, outperform personal judgements based on all types of considerations and experience.
You would need strong clubhouse leadership for that to work; it’s not just about managing X’s and O’s. The MLB manager’s most important role is to manage egos.
So perhaps this might be better suited for a Billy Beane type team where the players are relatively nobodys. But I think you’re going to have a tough time replacing the manager with a computer in a team filled with five-tool players who have been told their whole lives that they are the best at what they do.
Bobby Cox consistently made some huge strategic mistakes in the playoffs during the Atlanta Braves decade-plus playoff runs; however, he was consistently able to get his teams through 162 game seasons without any meltdowns, which I think is largely due to his ability to manage people.
Don’t get me wrong, Bobby had some top tier talent, but that just isn’t enough in a sport like baseball where the whole season is a grind, and half the league doesn’t get into the playoffs (like basketball).
I can’t agree less — the quality of the talent absolutely *is* overpoweringly the major factor in determining team success. Here’s a little gedankenexperiment. Here are two sandlot teams (because I’m too lazy to do full 25-man rosters); which one would you bet your money on?
TEAM A:
P You
C Bob Murphy
1B Lew Rockwell
2B Tom Woods
3B Hans-Hermann Hoppe
SS David Gordon
LF Peter Klein
CF Andrew Napolitano
RF Peter Schiff
MGR Casey Stengel
TEAM B:
P Walter Johnson
C Johnny Bench
1B Lou Gehrig
2B Joe Morgan
3B Mike Schmidt
SS Honus Wagner
LF Barry Bonds
CF Ty Cobb
RF Babe Ruth
MGR Paul Krugman
Assume for the sake of argument that everybody’s at his absolute peak of relevant ability. So which one do you bet on? For one game? For one series? For a whole season?
Yeah. Clearly the manager is *far* less significant than the actual players. How much less significant is an open question.
Well, if I had said, “Bobby Cox had some top tier talent, and everybody else in the National League had a bunch of Paul Krugmans, but that just isn’t enough….”, then maybe you could accuse me of suggesting that the manager is the overwhelmingly factor in the success of a baseball team.
I mean, would you rather have a computer company with a team of software programmers run by me (I have no software knowledge), or a team of garbage men run by Steve Jobs? Which one you bet your money on?
Who would you rather bet on in a survival situation? Les Stroud in the middle of the Sahara desert or you in the Garden of Eden?
I got bad knees, don’t put me at catcher.
Sorry, we don’t allow players to make decisions like that, you’ll have to discuss it with your Monkey.
Err, you Manager I mean… look, he works for peanuts, so we have more money to spend on your next knee replacement, so everyone wins.
Excellent…
I forget, how much of my allotment of smug comments do I have left?
Josiah you’re already in the hole 87 smug comments, using a discount rate of 3%.
Had there been a computer to tell Nelson Cruz where to stand in the outfield, the Texas Rangers would have been World Series Champions in 2011. Basically, Cruz had to play in a position so that a non-homerun fly ball could not get over his head. Between Cruz and Ranger’s manager Ron Washington they never figured out he was out of position until David Freese knocked a two out, two run triple over his head in the bottom of the ninth inning. That hit sent the game to extra innings where the Rangers were prevented from winning their fourth game of the series, and eventually, a game later, lost the series to the Cardinals in game 7.
Good one Murphy.
I know EMH is false because if every investor adopted it and used it as a principle for action, the market would collapse. Not every single investor can only buy an index linked mutual fund. If every investor only bid for it, there would be no sellers. Buying and selling can only take place if investors believe that active management works. EMH cannot be a valid description of real world markets. It is a thought and ideal only.
MF,
Listen to Eugene Fama’s Econtalk. He says that prices can adjust to new information simply by moving the bid ask spreads without any transactions taking place. I like the EMH because even though it is not a literal description of reality, it points investors in the prudent direction of buying index funds/broad market ETFs and I find that it gives you a useful framework for looking at market responses to new information. Other approaches to the stock market just aren’t as useful. Until there is a description of financial markets that is as/more useful AND realistic, I’ll stick with the EMH.
John Becker,
How in the world can “Only buy index funds” possibly be “useful”? If every investor only bid for that index, there would be no sellers of that index. And what’s more, if every investor tried to buy that index, the individual stock components would cease to exist. The only reason that an index fund can exist at all is because there are investors who are not only selling that index, but selling the individual stocks from which that index is constructed.
EMH is not useful. It can’t be. A useful approach to investing must have, at minimum, no seed for destroying the entire stock market.
The only reason you can even be in a position of buying a stock market index is if therr is a seller of it, and if there are sellers of the individual stocks. Your “useful” approach to investing logically presupposes the existence of investors who REJECT that claim to ideal, useful investing!
How can you not see this?
MF,
Informed traders drive EM. Informed traders care not a whit for EMH. They don’t need index funds. Index funds and EMH are for the rest of us.
John Becker
Also, if the only useful thing for an investor to do is buy an index fund, then that index’s price could not even adjust to new information. Every investor would inquire “What is the index currently selling for? I’ll buy however many units I can buy with my money available for investing”, then there would be no investors providing any ask offers, and so every investor would be inquiring about an ask price that does not even exist.
The only reason you can buy an index fund is because some investor somewhere in the world thinks the existing price “too high”. They are offering an ask because they DON’T want to only buy the index from someone else as EMH would suggest is the prudent course of action.
You don’t see any downside to all investors buying only index funds? In other words, it’s no problem if no investors are looking at individual company fundamentals? What about the whole concept of risk/reward? I’m not obsessed with money and I’m frankly too bored with index funds. I get value out of the challenge of investing, although I do use ETF’s strategically, especially as bubble money floats around the planet.
Exactly!
EMH could only be true so long as many investors do not believe it. As soon as everyone believes it (and acts accordingly), it becomes untrue.
At some point, not just “the stock market,” but business and entrepreneurship itself collapses. If active management in the financial sector is a fool’s errand, why would it be any different in any other industry. Hey, no sense trying to invent a better way of _____________. If it were that much better, our competitors (aka “the market”) would have already thought of it. All companies will play “fast follower” and invest more capital in the (efficient) markets rather than “actively manage” projects to innovate their product/service.
Brian,
EMH isn’t even true if investors don’t believe it. Investors adopting it intellectually and acting on it doesn’t turn what used to true into something false. It was false the whole time; acting on it just made that explicit.
I think EMH is a theory that springs not from painstaking self-reflective analysis, but of an acute fear or resentment towards the idea that the market is chaotic. There is this unwillingness or inability to understand how in the world the market can appear to “work” if it is based on chaos. They see patterns with some regularity, they think logically, and they need a “model”. They refuse to accept the market is not ordered and not intelligible and so they try to think of the market like a physicist or engineer thinks of a work engine – an object with “efficiency”. They think a system without laws can be transcended, but they can’t transcend the market. Ergo EMH is born.
The market is more chaotic than the Mandelbrot set.
MF,
While not having studied it specifically, I find EMH compelling enough to warrant further study. You might think I am biased towards it. Yet I am not at all how you imagine.
I read Market Microstructure (sic?) and find price action and price discovery to be fascinating. I take solace in the chaos, applauding predatory HFT and stop-hunting sawtooth action. I like to make the analogy to the quantum world, which is noisy and chaotic. That perfect looking, discrete, hide bound ball is just a loosely organized collection of molecules, the components of which we can only talk about in a statistical and not finite or discrete sense. Zoom out far enough though, and we really can talk about the price of tea in China.
Btw, I’ve read many several books positing alternative hypotheses like Robert Shiller and Benoit Mandlebrot and haven’t found their way of looking at things as useful or coherent.
There are more alternative theories out there than what Shiller and Mandelbrot have proposed.
I think I get it: investing by the EMH is like following all of the other investors who have already valued given assets. Indices like the S&P500 are chosen based on actions taken by people actively seeking a higher return (including active investors that don’t run the company, but just buy the stock.) If nobody tries to actively choose investments, then the passive investors will just keep bidding up nonsense (or the last set of companies/assets to have been chosen by active investors in the last period in which they could actually invest actively.)
Going back to the joke about the $20 on the ground, where the Chicago prof says it must not really be there — this works as joke because it takes a literal, obtuse view and yields an absurdity. I think it’s quite illustrative on non-humorous grounds:
1. The prof is saying that as markets approach efficiency, EMH makes it more likely that our perception is wrong (the $20 does not exist in a way that we can retrieve it) or that retrieving it will not be as beneficial as imagined. This is because as “foot traffic” increases, it becomes less likely that any one individual will be the first to spot it.
2. EMH does not deny that ~someone~ picks it up. In fact, EM depends and demands that someone pick it up. It’s just overwhelmingly likely not to be ~you~, having already been picked up.
I know it seems like a paradox or contradiction, but it’s not difficult for me to internalize. Try it this way: will a given $20 last longer in a high traffic area or low traffic? A sort of converse is that high traffic areas have more dropped $20s, but they get snatched up more quickly.
If your strategy is to go around picking up $20s on the ground, then success requires above average visual acuity (financial analysis ability) and either luck or specific, uncommon knowledge relating to that $20. And try not to drop any yourself.
I must be missing something. If dollars are dropped and picked up at a specific rate, why would the amount of traffic matter at all? Unless people guard their dollars more as traffic increases, or stop looking down and they end up in the street sweeper, the odds of finding a dollar don’t change.