Efficient Market Hypothesis & Distributed Ledger Technologies
"Two economists are walking down the road when they found a stack of 100$ bills. One turns into the other and says ‘Don’t bother, if it were real somebody would’ve picked it up!'"
Among many theories which constitutes the core of economic schools, Efficient Market Hypothesis (EMH) suggests the intuitive approach of any human being when they encounter an opportunity. Spontaneous feeling that keeps majority cautious before they make their move is shaped upon the fact that profit is only available when there is information asymmetry. However, what are the chances? This article briefly discusses if EMH is the reality or just a myth.
After Eugene Fama’s proposition of EMH in 1960, the definition kept expanding with the contributions of both notable academics and the market players. Malkiel (1992) has widen the perspective with following definition: “A capital market is said to be efficient to if it fully and correctly reflects all relevant information in determining security prices. Therefore, more formally, the market is efficient with respect to some information set. ..if security prices would be unaffected by revealing that information to all participants.” This puts forward once again the impossibility for one to make profit on the basis of defined and available information set.
What we deduce from the Malkiel (1992) definition if the market is efficient the company market value should be an unbiased estimate of the true value. Nevertheless it is important to stress that:
1. Market efficiency does not require that market price is equal to the true value.
2. There is an equal probability that stocks over or under valued at any point in the time.
3. And finally, investors should not be able to consistently identify under or over valued stocks using any investment strategy ( Damodaran, 2006).
What are the implications of the market efficiency from the individual investor perspective?
Firstly, equity research is costly and provides no benefits. Secondly strategies that have minimal execution costs such as randomly diversified portfolio or indexing to the
market would be superior to any other investment strategy. Thirdly, a strategy that has minimum transaction costs should provide higher returns in the long run (Damodaran, 2006).
Nevertheless it is important to stress that markets are not efficient due to their nature, but they are driven to efficiency by the actions of the investors. Therefore Roberts (1967) distinguished among three forms of the market efficiency:
1. Weak form: The information set includes only historic data.
2. Semi strong: The information set includes publicly available information.
3. Strong form: The information set includes all information know to any market participant and includes private information.
Such segregation can be perceived as a vain effort because clearly in reality cumulative intelligence is rather far from instant adoption even if all information is available. Secondly, since the market decision making mechanisms are super dynamic, ever changing strategies are never fully reflected which creates asymmetric information even if the technology encompasses all market players. Lastly, individual rationality should be debated with the consideration of EMH can only function in the existence of reasonable decision making.
Under the influence of latest technological innovations upon decentralization and distributed ledgers (DLT), behavioral finance has shifted towards understanding the consensus motivations between non-communicating parties. On famous attribution being the byzantine generals problem (1982) briefly emphasizes how deeply we are and will be in the need for validating information among all players which not only makes sure every individual is on the same page but also requires their confirmation. Blockchain and AI, being my fields of interest, has proved me several times that economic hypothesis, like EMH, are doomed to be criticized as long as the ideal economic proposition does not include technological devices as market players. Even more interesting is that innovations like smart contracts, automated audit and management systems etc. are positioned similarly radical in a sense they expect players to be fully informed and rational. In that regard, I believe economic studies have no reason but to evolve so we might have an actual chance to stop perceiving EMH a myth and start calling it a real phenomena.
Sources:
I definitely agree that we are going through a huge paradigm shift, where the existing theories of economic models that are being lectured in universities and colleges with the past 10-20 year's texts are no longer sustainable and will be replaced by new perspectives of behavioral economics. Sharing economies, blockchain technology integrated with AI and IoT based solutions are creating new standarts and models, and what we experience is that changing basic needs and behaviours of the individuals are the factors feeding this brand new phenomena.
ReplyDeleteGood work and very fruitful article, enjoyed reading it. Congrats