Thursday, December 4, 2014

Quick Follow-up on Inefficient Market Hypothesis (IMH)

Following on my earlier post, where I propose that the lack of reliable excess returns is not that dependent on efficiency, here is a short hand for levels of market efficiency.  These are roughly in order from contexts with the least amount of available excess returns to contexts with the most available excess returns.:

Strong EMH (prices reflect all public and private information)
Nobody can earn excess returns.

Semi-Strong EMH (prices reflect all public information)
Only insiders can earn excess returns.

 Weak EMH (prices are independent of past prices)
Excess returns without inside information are possible, but aren't persistent.

Weak IMH (investors are occasionally nearly universally unreasonable)
Persistent non-insider excess returns are only available in the (unlikely) event that you aren't bonkers.

Semi-Strong IMH (there are occasionally broad social pressures against being reasonable)
Persistent non-insider excess returns are available if you are willing to be frequently embarrassed and demonized.

Strong IMH (legal enforcement of inefficiency)
Persistent non-insider excess returns are available where there are an insufficient number of unregulated potential marginal investors.

In practice, strong IMH is widely available, but vulnerable to regulatory shocks.  Semi-strong IMH is widely available, but requires a decent amount of skill and clinical depression.  Weak IMH and weak EMH are difficult to distinguish from one another in practice.  Most punditry, including my own, and trading is from the presumed point of view of Weak IMH, but in hindsight is usually a confirmation of Weak or Semi-Strong EMH.  Even where investors, like Warren Buffett or Charlie Munger, spend a lifetime operating in something that looks like Weak IMH, there isn't enough evidence to clearly settle the issue.  Of course, if IMH is operative, who would we depend on to confirm it?

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