Thoughts from
San Diego on Law, Politics, and Culture

 
Why Efficient Markets are Random
By Tom Smith

Thanks to Steve Bainbridge for alerting me to an article in Nature that takes a swipe at the Efficient Capital Markets Hypothesis. I explain this to at least one of my classes every year, and from glancing at the summary of the article by the geniuses at the Santa Fe Institute, it looks like they may not understand the connection between a randomly walking market and efficiency any better than my most innocent students. Granted, I have just glanced at the article, so I'm jumping to this conclusion--but look: The reason why random stock market movements are evidence of efficiency is because stock market price changes are based on new information. If we could predict it, if it wasn't a surprise, then it would not be news. As I tell my students, that's why it's called news. The more random the movement, the more prices are reacting only to new information, rather than to information that is already (partially) reflected in past prices. So the folks at Santa Fe Institute have noticed there is more than one way to produce a random series. Well, duh. Non-randomness would not be an indication that traders are intelligent; it would just be evidence that the market is not processing information efficiently, that old news was still influencing current prices. Perhaps this example will help: suppose corn futures prices depend only on weather variables in the midwest, which I postulate fluctuate randomly. The movement of corn futures prices should be just as random as the weather movements, or else they are not responding only to new information. If there is anything not random about the movements, such as gradual seasonal warming, then that already known information should already be incorporated into current prices, and only unpredictable movements in weather variables should cause price changes.
posted by thomas at 9/25/2003 04:48:00 PM