One of the most important, but controversial, ideas of investing is the ‘efficient market’ hypothesis.

I say important, because it provides a great starting point for approaching investing and markets humbly, as well as for approaching the Financial Infotainment Industrial Complex with a healthy dose of skepticism.  Most investors would be better off if they understood and believed in the efficient market hypothesis.

I say controversial because extreme – or rigid – versions of the efficient market hypothesis can be either disproven or mocked or shown to be untrue in a variety of ways.

Why is this on my mind?

In the next few days I’ll be posting a podcast interview I did a few months ago with author Lars Kroijer, whose book Investing Demystified builds on the basic idea that very few of us actually have an ‘edge’ in the markets. As a result, we would be better off adopting a simple, low-cost approach to our investments.

Reviewing that podcast interview reminded me of my favorite presentation of the efficient market hypothesis, from Nate Silver’s The Signal and The Noise.

Silver doesn’t accept the discredited rigid definition of the efficient market hypothesis, but rather builds a series of increasingly accurate versions through steps 1 through 7.  I read this portion of the Silver book to Kroijer, so I thought I’d just post the transcript of our interview here, as a preview to the upcoming podcasts:

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Michael:          My favorite version of the efficient-market hypothesis was written by Nate Silver in The Signal and the Noise. Have you read that book?

Lars:                No.

Michael:          Do you know who he is?

Lars:                The New York Times guy? [More recently, ESPN, of course]

Michael:          Yeah and Fivethirtyeight.com where he does political forecasting. He’s an interesting thinker and I really recommend the book. But he has a statement of the efficient-market hypothesis that matches his view of the world, which is a probabilistic view in which you end up saying things much less certainly about the future, but maybe more accurately, because the future itself is uncertain. He has seven levels of the efficient-market hypothesis, which I just want to read to you, because it’s really fun.

Level 1:  “No investor can beat the market.”

Okay, that’s very strong, very simple.

Level 2:  “No investor can beat the stock market over the long run.”

That’s a bit, more qualified.

Level 3:  “No investor can beat the stock market over the long run, relative to his level of risk.”

Okay, that’s more sophisticated.

Level 4:  “No investor can beat the stock market over the long run, relative to his level of risk, and accounting for transaction costs.”

Okay, makes sense.

Level 5:  “No investor can beat the stock market over the long run, relative to his level of risk, and accounting for transaction costs, unless he has inside information.”

Makes sense.  The second-to-last one is:

Level 6:  “Few investors can beat the stock market, over the long run, relative to their level of risk, and accounting for the transaction costs, unless they have inside information.”

Finally, the most complete version of the efficient-market hypothesis, which makes sense to me.

Level 7: “It is hard to tell how many investors beat the stock market, over the long run, because the data is very noisy. But we know that most cannot, relative to their level of risk, since trading produces no net excess return, but entails transaction costs. So unless you have inside information, you’re probably better off investing in an index fund.”

Lars:                I like that.

Michael:          He’s a good writer and he has an awesome way of talking about how do we understand the future in a probabilistic way. It’s a sophisticated way of talking about the different levels of extreme efficient-market hypothesis, versus a more – probably correct – nuanced way.

Lars:                I think unfortunately the way it’s sort of been very roughly done in theory, it’s sort of been discredited.

Michael:          If you go to the extreme version, you can discredit it, I think.

Lars:                So no one will really look at it today. It’s not something widely discussed. One of the reasons being is that not many people are really all that interested in discussing it widely. I like what he’s talking about.

Please see related post book review of The Signal and The Noise, by Nate Silver

The Signal and The Noise

Please see related post book review of Investing Demystified, by Lars Kroijer

Investing Demystified