Thursday, December 4, 2014

You should invest passively because markets are INefficient.

In a comment on my mini-rant the other day, pkd mentioned the trend among the intelligentsia of referring to our current era as "late capitalism", discussing capitalism as if its long-expected demise has finally arrived.  Stagnation, inequality, unsustainability...these are the concerns of the day.

It really is amazing how regularly backward human intuition is regarding emergent systems, particularly in financial and economic matters.  The internet, together with wireless telecommunications and computers themselves, is arguably the most awesome non-organic development ever to grace the face of the earth.  For the most part, it was developed, created, and disseminated to even the most destitute parts of the world in the time it takes a Western child to reach adulthood.  It is a revolution, it's universal, and it happened in the blink of an eye.

So, today a teenager can develop a piece of software that spreads across the globe, and become an instant billionaire because millions of people voluntarily remit to her some small portion of its value.  The rest of us, meanwhile, bathe in a sea of abundance and opportunity that was unimaginable before.  Why, I'm bathing in it right now, as I share my thoughts with you via my blog.  It's a cornucopia, much of which is provided at no direct charge, with (literally) immeasurable value.

And, our intuition sees this newfound wealth and this sea of immeasurable services, and screams "Stagnation! Inequality!"  We literally could not be more wrong.  And it comes so naturally.  No wonder the God of the Old Testament was always so angry.  We really are insufferable.  And, many people say, "You know what got us out of the Great Depression?  World War II.  Sometimes the  cure for stagnation (like living through this dark era when the internet was developed) and for inequality (says Picketty) is a good old fashioned war."  I'm not making this up.  This is a thing.  A very common belief.  Maybe the typical belief.

Anyway, this got me to thinking about the Efficient Market Hypothesis.  Emergent systems like modern markets are so effective at coordinating effort that it usually takes a peculiar cultural or regulatory obstacle to keep economic activity from dynamically moving in the right direction.  In unencumbered trading markets, for prices to fail to efficiently reflect costs, risks, and opportunities, we really have to be nearly universally out of our minds.  And, yet, as human beings, we are quite clearly capable of just that.  Evolution can bumble along without a bit of intention or forethought, and make you an opposable thumb just when you need it.  Monkeys throwing darts could do a decent job managing your portfolio.  But, human beings, we can burn witches or bleed the sick for centuries without having a doubt.  Observe a big enough group of us, and we will always underperform the monkey with the dart.

So, here's the thing.  We normally say markets are pretty efficient, so just about everyone should invest passively.  We talk about weak, semi-strong, or strong efficiency.  In any case, the idea is that prices probably already reflect any marginal information you are likely to have.

I am going to suggest another form of EMH.  I'll call it Weak Inefficiency.  If, as a group, we are so bonkers about something that even the incredible mechanism of dynamic markets can't pull the price to its efficient place, then each additional trader is likely pushing the price away from efficiency.  So, yeah, most prices are probably reflective of rationally applied information.  So, you should invest passively.  But, if prices are wrong, then run like crazy from that market.  You are probably out of your mind.  If markets are inefficient, you better believe you should invest passively.

And, if they are inefficient, you might be crawling out of your skin, dying to trade.  You might be absolutely certain of yourself, even as you are bass ackwards wrong.  When you feel that way, you might just be correct - inasmuch as the market will be inefficient.  And yet, then, more than ever, you better be passive.

In fact, we can probably describe the IMH with its own weak, semi-strong, and strong forms.

Weak IMH - voluntary inanity
Semi-Strong IMH - inanity enforced culturally or through unorganized force
Strong IMH - inanity through organized force

The libertarian project really mostly boils down to pushing things back from strong IMH to weak IMH.  Marge Simpson probably gave us the slogan for IMH after she failed to cancel the Itchy and Scratchy Show.  "I guess one person can make a difference, but most of the time they probably shouldn't."



  1. Kevin: REITs. Sometimes a REIT will trade above net asset values and sometimes below. But it seems to me that a REIT market cap and its net asset value should always be the same. BTW you can buy REITs for some Southern European nations now at 50% of NAV.

    1. I don't think there is a systematic, persistent gain to be had from naively trading against NAV gaps, is there? But, regardless, that's certainly an interesting speculative idea. Do you have some ticker symbols to suggest?

  2. That's a good question. I think there is, due to the threat of going private transactions. Also mortage REITs are way interesting.