Whenever I listen to the daily financial news, especially the details about market turnover (millions of shares or USD) I cannot stop wondering: These turnovers are made of millions of transactions, each one of them involving a buyer and a seller that agreed on a price and quantity. The former enters into the deal expecting a positive yield, while the later assumes exactly the opposite. Someone must be wrong, isn´t it? Better said , who is the smart guy and who´s the sucker? The seller or the buyer? From the outset, it is impossible to know, but what it is clear is that someone MUST BE wrong. If is this the case, how can anyone claim that financial markets are rational or “Efficient”??
The Efficient Market Hypothesis (a leading theory behind financial models) tries to explain that apparent incoherence through an interesting mechanism: Individually, the market players can be wrong, but collective wisdom (i.e. “The Market”) is always efficient /correct. The explanation goes like this: Markets are efficient in the sense that prices reflect all the available information in the market, visible and invisible as well .Nothing escapes from the definition for “information”: Raw data, analysis, beliefs, technical analysis, crystal ball , dart throwing monkeys on a WSJ table, etc. As a matter of fact, that definition is a tautology since it is obvious that prices are the ultimate output of all the inputs involved in the process.
The main practical conclusion from EHM is self evident: Since all the info is on the table, there is no one with a real advantage so excessive returns in the long run are due to luck (i.e. the fees you pay to your fund for stock picking or the “analysis” is a waste of money….). From an academic point of view, EHM is the epicenter of passionate debates until these very days. I will not enter into a wonkish zone since my main concern is the broader aspect of the market efficiency postulates.
Financial market “efficiency” corresponds to the (quasi religious) belief that markets are the best mechanism for resource allocation. That questionable theory got several implications beyond the finance arena, well into the social and economic life, and I could mention at least two conclusions from EHM, relevant in a broader context:
First: If financial markets are efficient, external intervention should be minimized, including regulation of governments and public entities.
Second: Since financial markets are supposed to be the best proxy to a pure version of a free market and as such serve as a model. The logic is simple: If financial markets are efficient, then society should apply the magic “free market “formula to other markets as well.
As mentioned above, the first conclusion is questionable as the efficiency of the market is not more than a tautology. On my humble opinion financial markets are the sum of clashing forces (supply vs. demand etc.) which get into terms by the end of the day through the exchange mechanism. The price is the outcome of perceptions, expectations, alternatives; cash constrains, bargaining power and other, so there is nothing really right, wrong per se in the price set. The concern from social point of view which justifies a strict oversight on these markets is possibility for more than probable bad repercussions (externalities) from the market could affect the whole society.
The second conclusion could be interpreted in a different way. If free markets are not more than clashing interests and perceptions, the internal oversight (such, auditory work) is there to deal with these forces that market mechanism alone cannot handle properly (inside information as an example). In that sense, since society is a much bigger fighting arena of clashing interests, it can also define those the areas beyond the arm reach of market mechanism and its clashing forces.
Summarizing: There is nothing really magic in the price mechanism of financial markets, it is just a balance between clashing forces, which requires oversight and vigilance, sometimes even offsetting “efficiency”. The same applies to the economic structure of the society
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