“Efficient Markets” Eliminate Risk


Economist and Bloomberg View columnist Noah Smith recently posted an article titled When to Send an Investing Model Into Retirement. The gist of it is that Eugene Fama’s efficient markets theory was not withstanding the test of time; frequent revisions regarding the risk model associated with the theory had basically invalidated it.

That got me thinking about the nature of “risk” as it is associated with Capitalism and the idea of “efficient markets.” I can’t claim to know the ins and outs of Fama’s theory but it struck me that in a perfectly efficient market, risk should not exist.

To illustrate, consider the idea of perfect prescience. If a person was perfectly prescient, risk would not exist for them as unpredictability would be eliminated. The act of knowing the future also informs a set of actions so, not only would you know the future, you would also know what actions to perform in order to derive or avoid any specific result. The same goes for markets. As more and better information becomes available, unpredictability is systematically eliminated. So it stands to reason that, as more and better information becomes available, market risks drop. I view this as an unintended consequence of the World Wide Web: the unfettered proliferation of information is systematically eliminating the very thing that makes outsized investment returns possible.

In a world where information was scarce or difficult to discover, the diligent had an advantage, it was simply a matter of finding a vital piece of information that few others knew. But those dynamics have changed in a world of abundant information. The odds of discovering high-quality information that others don’t also have has shrunk substantially. In other words, from an information perspective, markets have become far more efficient.

So, in a world of better information, how does one gain an edge that would allow them to reap outsized investment or trading returns? The only answer possible is market manipulation. In other words, the proliferation of good information naturally breeds a proliferation of bad information. Oddly enough, this re-strengthens the value of good information as it becomes harder to discern it from the bad.

In a world of abundant information, the ability to discern the good from the bad becomes the essential trait for creating an investing edge. How do you know if you have cultivated that quality? It manifests as predictability. In other words, the ones who have properly cultivated the ability to discern good information from bad are able to predict events with a high degree of accuracy. This is where I feel that machine learning (ML) has a distinct edge over humans… machines have no biases or egos. My expectation is that, eventually, machines will obsolete humans entirely when it comes to investing. Those humans who outperform markets in the future will almost entirely be market manipulators and purveyors of false information.

What many people don’t get it that it is the distortions within the Capitalist system that create the opportunities for outsized wealth, the key factor of which is a general state of unpredictability. Anything that eliminates unpredictability, by nature, also eliminates risk and, therefore, extraordinary opportunity.

This also explains why venture capital (VC) is likely the future of investment. It’s an entire industry predicated on attempting to predict the highly unpredictable. That is why it is important to challenge its current nepotistic and patriarchal nature. A “good ol’ boy” system defeats the purpose of VC as does any behavior that is subjectively exclusionary.

Here’s a test for you: how good is your favorite investor or analyst at predicting the future? There are many great writers and thinkers out there today but I have yet to be impressed by their ability to cognize the future.

To summarize, good information eliminates risk; as more good information proliferates, market distortions will increasingly be created by introducing bad information. The ability to discern the former from the latter will become the essential trait of the great investor, at least until machines take over.

However, in the end, it is the ability to accurately predict the future that has and will ultimately always have the most value. But how did that work out for Cassandra?

P.S. – Another thing to consider is that systems will increasingly become rigged as a means of gaining returns without risks. Think of a casino, where the mathematics of the games guarantees the profitability of the “house.” But such a condition also invalidates the rigged system. I suspect that many professional sports, particularly NFL football, have become rigged. The financial incentives are simply too great for them not to be. But that’s just speculation. Pound of salt, etc. However, also keep this in mind.


One thought on ““Efficient Markets” Eliminate Risk

  1. Pingback: AlphaGo and the A.I. Apocalypse | The Currency Paradox

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