2009-09-10

Surprise: Like our cars, our markets are not efficient

This is an awesome writeup from the NY Times by Nobel Memorial Prize winner Paul Krugman about the state of macroeconomics today. It's long, but really good, if you're interested in this sort of thing.

I'll admit that I've never been fully "in the loop" with macroeconomics. I think you have to study the subject regularly to do so, but the way Krugman describes the situation is very compelling. He lumps American economists primarily into two groups: "freshwater" and "saltwater". The freshwater economists (sometimes loosely called the Chicago School) love Friedman and the efficient market hypothesis, while the saltwater guys lean towards Keynes and possibly more government intervention.

I wish I knew more about the subject; if you're interested, read the article. One thing I do know is that my first few finance classes (I have minors in finance, and economics) focused on the efficient market hypothesis. Everyone likes to think that competition, rational investing, and arbitrage cause every price in the market to be where it should be, employment/unemployment included. Yet somehow they all want to find the "best" investments in the stock market or wherever. If pricing was perfect, all investments would be equally good, given the risk involved.

That's why I never bought the efficient market hypothesis. Being a methematician, I can prove this. Let's assume a stock appears on the market, perfectly priced. Several smart traders trade the stock, keeping it perfectly priced as news and developments of the underlying company become known. Then, one not-so-smart investor---let's call him "I Know This guy Who's a Stockbroker"---he starts trading the stock. If Mr. Stockborker is not listening to the news, or if he's just stupid, he makes the wrong trade at the wrong time, and all of the sudden, the pricing of the stock is not perfect any more. Bingo. No more efficient market.

Yeah, yeah... I know; it's all a question of scale. One guy won't change the market, but a thousand people with the same or similar idea might, and that's the kind of things that develop over time, creating a bubble. All it takes are a few people who buy houses simply because their parents told them "a house is the best investment you'll ever make", and the modest price increase caused by these people makes housing look like a better investment to more people, and the chain continues.

Maybe this particular example is circumstantial, but there's nothing keeping the prices grounded to the truth when people are ignoring investment fundamentals and are participating in what Krugman calls "ketchup economics", which is when people see that a half-liter bottle of ketchup costs half as much as a one-liter bottle, and assume that pricing is efficient. No one knows how much ketchup should cost, without looking at a ketchup bottle of a different size.

There are a lot of investors who buy the most undervalued stocks in the market. This works well until all stocks are overpriced. One guy who never forgot that, who never got caught up in the efficient market hypothesis despite its tremendous popularity, is Warren Buffett. He pulled completely out of the stock market during the 1972-73 boom, and people called him crazy for missing out on the gains that other popular investors of the day were making. Then everything crashed, and no one was laughing, not even Buffett, because he knows it's not a game.

Buffett steadily climbed Forbes' World's Richest list, and appeared second on the list for a few years before finally claiming the number one spot. When? In 2008, as the market again took a spill.

I'm going to have to read Keynes.

No comments: