There is an absurd theory that is so unrealistic that it is bizarre that anyone actually believes it. It views the stock market as a perfect place of logic and reason where nothing can go wrong. It ascribes stock traders with the powers and knowledge of a God. The fact that so many believed in it was a major cause of the recent asset bubble and financial crash. It is known as the Efficient Market Hypothesis.
To enter the world of the efficient market hypothesis you must leave your brain at the door. The theory assumes that all traders in the market have perfect information. That is to say, they know everything there is to know about every company on the stock market (it gets worse). Not only do they have all the information in the world, but they all perceive it in the exact same way. Even more ridiculously they are assumed to know the future of the company as well. Basically every trader is assumed to know everything about every company, both know and in the future. Every trader is also believed to view this information in an identical manner and reach identical conclusions completely independently of everyone else. They are assumed to be all-knowing gods living in a bubble separated from the rest of mankind.
I’m not sure if there’s any point criticising this theory, it’s hard to see how anyone can honestly believe it. The only non absurd point of it is its conclusion. It argues that because every share price reflects its true value and future earnings (as if!) it is impossible to make money off the stock market. That point is not unreasonable though there are numerous exceptions. The reason it’s so difficult to make money of the stock market is because it is so irrational, not because it is perfectly logical and efficient.
The main point of the theory is that undervalued or overvalued shares do not exist. The only way you can hold this belief is if you are totally divorced from reality. The financial crisis was a clear example of shares being wildly over valued before traders panicked and the market crashed. Under the hypothesis bubbles cannot happen because the stock market will decide a share’s true value, no higher no lower. The fact that bubbles do happen is the one clear and unequivocal proof that the efficient market hypothesis is nonsense.
If the theory was true than every trader would end up with similar results, the only difference due to random chance. It would not be possible to consistently make large profits, but neither would it be possible to lose large amounts of money on the market. All traders would get roughly similar returns. The fact is that this does not reflect reality. Warren Buffett is the richest man in the world due to consistently winning money on the stock market and has claimed: “I’d be a bum in the street with a tin cup if the market were efficient.” He has pointed to a number of other investors who have grown wealthy by following similar logic to him.
Steve Keen notes that if the theory is true than once equilibrium price is reached for a share, trading should stop. There is only so much news regarding a company, so that it is possible for a company to go days or even weeks without new information about it emerging. Therefore its share price should resemble a volcano, dormant for long periods with occasional flashes of movement. In reality share prices change thousands of times every day and it is absurd to suggest that these are all due to new information emerging.
The theory assumes that all future expectations are correct, that in effect all traders are prophets. The theory cannot survive if traders disagree, rather it must resemble some totalitarian dystopia where everyone thinks alike. The theory does not allow any space for peer pressure or herd mentality. Each trader operates in a bubble completely separated from everyone else and makes their decisions completely independently. There is no irrational exuberance and no jumping on the bandwagon. The simple truth is that traders do interact with each other and base their decisions partly on what others think. In the real world there is a large amount of group think in the markets as well as positive feedback to say nothing of self-fulfilling prophecies.
Behavioural economics is a developing field that is coming up with many ways in which people are not the perfect rational actors described in neo-classical theory. For example numerous studies have found that most people are overconfident of their abilities. Many display an ‘it-won’t-happen-to-me’ approach. While it is obvious that some people will lose money on the stock market, each individual believes they have above average talents that mean it won’t be them. This overestimation of their abilities leads people to make unnecessary risks as the crash has shown.
There is also the ‘Representativeness Bias’ where people attach too much weight to recent experience. In a way this makes sense as we forget the past and the future is unknowable so we focus on the present. This means people often presume things will continue the way they are and do not see future changes. For example it had been so long since the last crash and recession that people thought another one wouldn’t occur. They assumed that because the market was rising it would stay rising. The opposite also holds. Just as many could not see the boom ending anytime soon, so neither could people see the recession ending anytime soon, despite historical trends on both incidents.
At the height of the boom governments around the world refused to take action because they believed the markets were efficient, that stocks could never be over priced that traders were rational and logical. How wrong they were. If we ever want to prevent another crash from happening we must ditch the failed efficient market hypothesis, face reality and see the world for what it really is.