I recently engaged in a discussion of the Efficient Market Theory at the Early Retirement Extreme Forum. The thread is titled Is Efficient Market a Theory, Hypothesis, Fact, Law or Notion?
Juicy Excerpt #1: I want to be fair in my descriptions. I don’t want to underplay the extent to which I believe the evidence has been misinterpreted. I believe that this misinterpretation has caused a great deal of misery. So I want to be firm on this point. But I also want to be fair. I don’t want to be calling something a nation if it is really a hypothesis, or calling something an hypothesis if it is really a theory, or whatever. My question is — Is there anyone who can say what the true status of the Efficient Market idea is?
Juicy Excerpt #2: A hypothesis that holds true under certain conditions. It has never been proven mathematically…. You could try to prove EMT empirically and then say via scientific induction it will hold true forever more. But the past is a terrible way to predict the future, and definitely doesn’t provide the needed proof to give something the title of “theorem”. So I therefor say “not a theorem” and a “hypothesis”. You could then try and argue that the hypothesis has been disproven. I’d say it has, but you could say it holds true under certain conditions (like if you watch the market > 40 years).
Juicy Excerpt #3: The efficient market idea is best described as a hypothesis. It simply does not has the same level of evidence and support to be a theory. However keep in mind to be classified as a theory you need an overwhelming amount of evidence including many making many predictions that could be falsified to prove the theory wrong but were not. That said, there is still a strong amount of evidence for the emh, but not nearly at the level of say the theory of evolution. The way I view the emh is that it is a model that describes/predicts how some aspects of the market work. But to paraphrase the statistician Box, all models are wrong but some are useful.
Juicy Excerpt #4: You, Jacob, and Shiller have unveiled some things for me on finance. I moved 1/2 my 401k into “safe” funds for long term timing (Although, I really enjoyed September after I sold near end of August:)). I don’t feel bad though. I made the move entirely based off my reflection on risk tolerance. It occurred to me that I was not willing to potentially lose half my wealth again to mumble “in the long term” after reviewing how history repeats itself. Especially now that I soon plan to ERE.
Juicy Excerpt #5: Personally, I think the existence of bubbles, especially the ginormous tech bubble of ’96-’00 and the recent housing bubble, basically proves the failure of an efficient market. That said, I would rather gamble on solid value stocks and solid dividend paying stocks than to sit out the market until the market as a whole drops down to historically “fair” valuations.