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Efficient Market Fallacies November 18, 2008

Posted by A Texan In Grad School in Economic Theories, Uncategorized.
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Being a financial engineering student I constantly hear ignorant discussions of the EMH.  The biggest misunderstanding about the EMH for most people is the definition of returns.  The EMH does not say that it is impossible to make money using technical analysis.  It states that it is impossible to make economic profits with such a strategy.  Economic profits is a very precise yet loose term.  Economic profits (or rents) are revenues in excess of ALL costs, including opportunity cost.  You can make business profits, but if after subtracting opportunity cost and adjusting for risk you should have nothing left, or so the EMH states.

Some people point to Warren Buffet as evidence against the EMH.  Buffett is an extremely smart individual, which also means his opportunity cost is extremely large.  Secondly, he has a number of people working for him.  When you total all his costs and adjust for risk I doubt Buffett has any economic rents left over.

A common joke about the EMH takes the form of two economists walking down the street and one sees a $20 bill on the sidewalk.  He begins to bend over to pick up the bill when his companion says “Don’t bother reaching for the $20 bill, according the the EMH it can’t exist.”  So the two walk off.  The EMH doesn’t state that it is absolutely impossible to stumble upon a temporary profit like this $20 bill.  What the EMH states is that after picking up that $20 bill, it would be a waste of time to go back to that same spot and expect to find another $20.

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