What do physicists think of the Efficient Market hypothesis?

  • #1
beamthegreat
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Just wanted a fresh perspective on this considering that physics is more successful at modeling reality compared to finance.
 

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  • #2
BWV
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perhaps you could define it to your understanding as a lot of straw men get thrown about when this topic comes up
 
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  • #3
russ_watters
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What do physicist think of the efficient market hypothesis?
Just wanted a fresh perspective on this considering that physics is more successful at modeling reality compared to finance.
Your question implies that you think physicists could utilize their skills/knowledge to provide more successful theories/models of finance. I'm an engineer, not a physicist, but I suspect physicists are more confident in the motion of the planets than the markets because gravity is more reliable than human behavior.
 
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  • #4
Rive
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Just wanted a fresh perspective on this considering that physics is more successful at modeling reality compared to finance.
Well, physics is indeed able to tell that if you nuke it the value will fall.
But between the extremities it's mostly about psychology and economy, and those are not the same kind of science as physics => physics has nothing constructive to add.
 
  • #5
BWV
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Your question implies that you think physicists could utilize their skills/knowledge to provide more successful theories/models of finance. I'm an engineer, not a physicist, but I suspect physicists are more confident in the motion of the planets than the markets because gravity is more reliable than human behavior.

Although the human aversion to leaving free money around for the taking, which is the essence of the EMH, is at least as strong as gravity
 
  • #6
at least as strong as gravity

Besides the point, but I thought I'd point out that as fundamental interactions go, gravity is extraordinarily weak
 
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  • #7
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Besides the point, but I thought I'd point out that as fundamental interactions go, gravity is extraordinarily weak
But it kills more people every year than any other fundamental interaction...
 
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  • #8
gmax137
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but I suspect physicists are more confident in the motion of the planets than the markets because gravity is more reliable than human behavior
Human behavior on an individual level is quite unreliable. But maybe the behavior of billions of humans can be modeled reliably like we do for, say, a perfect gas. Maybe, maybe not. A billion is a big number but nowhere near as big as 6*10^23.
 
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  • #9
kyphysics
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Just wanted a fresh perspective on this considering that physics is more successful at modeling reality compared to finance.
Is your assumption that the EMH is true or false, by the way?
 
  • #10
TeethWhitener
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But it kills more people every year than any other fundamental interaction...
To paraphrase (and butcher) Douglas Adams: it’s not the gravity that kills you, but the sudden electron-electron repulsion at the end.
 
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  • #11
bobob
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Just wanted a fresh perspective on this considering that physics is more successful at modeling reality compared to finance.

I don't have a link but there are a series of articles written by Bruce Knuteson, "Celebrating Three Decades of Worldwide Stock Manipulation." Bruce Knuteson spent 6 years as a high energy physicist, was an assistant prof at MIT (PhD from Cal Berkeley) and spent 6 years working as quant in the financial industry. I think you'll find his opinion of an efficient market to be pretty poor. He describes in detail (with real mathematics and data, the marketing strategies used to manipulate the market and what kind of capital it takes to play at that level). Google should make these easy to find. I found one of the articles in arxiv in the mathematical finance section. I don't think the fact that the markets are manipulated will surprise anyone, but the schemes he describes are rather sophisticated somewhat counter intuitive intially (and illegal, but ignored by regulators).

BTW, one of the best physics and math departments in the world resides at Renaissance Technologies, which is an investment firm.
 
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  • #12
bobob
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Your question implies that you think physicists could utilize their skills/knowledge to provide more successful theories/models of finance. I'm an engineer, not a physicist, but I suspect physicists are more confident in the motion of the planets than the markets because gravity is more reliable than human behavior.

Some of the biggest employers of mathematicians and physicists are investment banks and hedge funds. They don't rely on human behaviour beyond detailed statitical analysis from real data, not any presumptions or preconceptions about how humans behave. Their trading is algorithmic and you would be surprised at the kinds of things they connect as derivitives (such as hotel occupancy and predicted cloud cover) and their trading times depend on making trades in milliseconds. There is not much difference between modeling planets and modeling markets from a data driven perspective. You collect data and derive a model. That is precisely why investment banks and hedge funds hire physicists and mathematicians as quants.

Renaissance Technologies will not even hire people with an economics or investment background.
 
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  • #13
kyphysics
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Some of the biggest employers of mathematicians and physicists are investment banks and hedge funds. They don't rely on human behaviour beyond detailed statitical analysis from real data, not any presumptions or preconceptions about how humans behave. Their trading is algorithmic and you would be surprised at the kinds of things they connect as derivitives (such as hotel occupancy and predicted cloud cover) and their trading times depend on making trades in milliseconds. There is not much difference between modeling planets and modeling markets from a data driven perspective. You collect data and derive a model. That is precisely why investment banks and hedge funds hire physicists and mathematicians as quants.

Renaissance Technologies will not even hire people with an economics or investment background.
Very interesting discussion.

Jim Simons is brilliant and his 60% annualized returns over decades(?) does speak for itself and beats Warren Buffett/John Templeton/Peter Lynch's (three of the greatest value investors of history) records. However, he keeps his methods mostly secret and I'm not sure we can say how much he takes from various disciplines (in terms of methodology and types of data gathered).

But, importantly, there just never has been any human alive with any method that can 100% predict the economy and/or markets. You can 100% predict things in physics if you understand the underlying laws and objects involved. That's not the case with the economy and markets. Warren Buffett has said that there are too many variables to try to even analyze to predict something as large as an economy. And then you have markets, which may or may not reflect the economy (often they don't - given human emotions that swing them overly in one direction or another), and involve figuring out the actions of free agents (which is impossible). No one has ever successfully modeled where market movements will go.

It's one thing to make money in the market, but it's another to accurately predict either the economy or market movements. You can do the former without having to nail the latter two.

Maybe physicists and mathematicians have a more useful skill set to try to model these things vs. economists and finance people - that could be up for debate - but I don't believe they can ever achieve natural science-like accuracy, given free human agents.
 
  • #14
kyphysics
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Something I've wondered is whether COVID has made people rethink their portfolios and/or diversification?

Imagine having the majority of your wealth in Hilton Hotels, AMC Theaters, American Airlines, etc.

How much diversification do you have/want in your stock portfolio?
 
  • #15
BWV
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Why is it the Efficient Market Hypothesis rather than the Efficient Market Theory? Economists are not shy from using the word theory in the same sense as in physical sciences- a testable model that describes a range of phenomena. Eugene Fama, the creator of EMH, explains in his Nobel Prize lecture:

It was clear from the beginning that the central question is whether asset prices refect all available information—what I labeled the efficient markets hypothesis (Fama 1965b). The difficulty is making the hypothesis testable. We can’t test whether the market does what it is supposed to do unless we specify what it is supposed to do. In other words, we need an asset pricing model, a model that specifies the characteristics of rational expected asset returns in a market equilibrium. Tests of efficiency basically test whether the properties of expected returns implied by the assumed model of market equilibrium are observed in actual returns. If the tests reject, we don’t know whether the problem is an inefficient market or a bad model of market equilibrium. Tis is the joint hypothesis problem emphasized in Fama (1970). A bit of notation makes the point precise. Suppose time is discreet, and Pt+1 is the vector of payoffs at time t + 1 (prices plus dividends and interest payments) on the assets available at t. Suppose f(Pt+1⎪Θtm) is the joint distribution of asset payoffs at t + 1 implied by the time t information set Θtm used in the market to set Pt , the vector of equilibrium prices for assets at time t. Finally, suppose f(Pt+1⎪Θt ) is the distribution of payoffs implied by all information available at t, Θt ; or more pertinently, f(Pt+1⎪Θt ) is the distribution from which prices at t + 1 will be drawn. The market efficiency hypothesis that prices at t reflect all available information is, (1) f(Pt+1⎪Θtm) = f(Pt+1⎪Θt ).

So you cannot test the EMH because you never know whether the market or your model is wrong.

Renaissance and Jim Simons is an interesting case - a clear example of a group that has achieved real excess returns. However, they appear to be alone - Three Sigma, their closest competitor, has returned no where near their performance. Also, the fact that Renaissance exists means that it becomes even more unlikely that you or your financial advisor will be able to consistently beat the market as they have mined most of the exploitable trading strategies that are out there, and the prices you then have to pick from reflect the impact of all of their trading.

Beating the market is a zero-sum game, so the average investor gets the market return less fees and trading costs
 
  • #16
Office_Shredder
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The claim is that all the people of the world come together to trade the stock given the information that they have, and when the dust settles the stock will be trading at the right price. Once you understand this, I think things become more clear

So there are a couple things here
1.) If people don't trade the stock, it won't be at the fair price.

2.) If you have some secret information that no one else has figured out yet, it won't be priced into the stock until you trade.

If a physicist can do modeling that figures out a profitable trade in a stock, it means no one has figured that out and traded on it before. What you generally expect to happen is that the rest of the world will figure out the same thing over time, and then a whole bunch of people will be competing to do the same trade, and the profit will do away. This is potentially what has happened to things like value investing - they were great ideas, now the whole world knows about it and tries to do that trade, so trading based on value is not going to make money anymore.

In 30 years all the algorithms that people think are the hottest thing around will be in the same boat, replaced by other algorithms or some fundamentally different way of thinking about stocks.

Also, fwiw, the trading that involves millisecond precision and the trading that involves the correlation of cloud cover to hotel occupancy are very different things.
 
  • #17
Hornbein
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Just wanted a fresh perspective on this considering that physics is more successful at modeling reality compared to finance.
I have a masters degree in statistics. In my opinion the efficient market hypothesis is a useful first order approximation of what actually goes on. There is much research these days of ways in which people deviate from mathematically correct rational behavior. On the other hand since it but an approximation I am distrustful of towers of mathematics constructed on this infirm foundation.

Some markets are quite efficient but in others the players may be ignorant.
 

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