Rational/ irrational

[Sanjeev Sabhlok <sabhlok@almaak.usc.edu>]

I had missed much of the 'fun' during November; still haven't caught up.

Vinay stated (11/11/98)

"EMH and theories like Random Walk are Idiosyncrasies that have
nevertheless gained their original proponents Ph.Ds and Doctorates. That
does not make them right.  Asset Allocation theory is another."

This issue is not as abstract as it appears. On this depends the
interpretation that we might make about markets, including financial and
other markets. 

There are 3 types of efficiency. Tests have been carried out for
verification of these forms. The weak form is generally supported [by
the way this is what I am speaking from memory: I don't have a text book
on this subject with me right now]. The strong form is not easily
supported. In other words, there are possible methods to make a slight
excess over the market, consistently. But such arbitrage opportunities
are usually very thin.

Vinay: I do not say that stocks are not a fine way to invest. In fact, a
good portfolio must have stocks in it. Stocks have beaten treasuries by
manifold over the years. I have a nice chart showing that a dollar
invested in early 1900s in small company stocks vs. a dollar invested in
treasuries would have beaten the bond investment by many thousand times
by now. All I say, or the EMH says, is that you cannot easily beat the
overall market index. The key is not that, but that markets rationally
price all possible info on the future cash flows of a company. In other
words, unless you have inside information, or you have a rather
exceptional strategic analysis of the globe, you cannot easily do better
than simply holding an index fund. 

Of course, that implies, at the very minimum, that just as the IPI
manifesto, in the end, will capture all possible information in the
determination of the best policy, so also, the markets are superior to
any single individual in determining the value of an underlying asset.

To prove scientifically that it is possible to make excess returns over
the market is a pretty difficult job. As a simple case, you can try
doing it publicly, by letting us know your investments today and the
progress of these investments at regular intervals over the next 50
years. If you beat market indices then you might have a point to make.
Simply beating the market once or twice is not enough empirical proof.

In other words, my claim (not mine, but the claim of all economic
science and financial studies) is that the EMH is more correct than
incorrect. Markets are more rational than irrational. In any case, a
planner (even if we were to annoint you as India's Great Planner) will
always do worse in the determination of the price of millions of
commodities, than the market (cf. Hayek).

There are many, many Nobel prizes waiting (about $1 million in value,
each) for people who can prove the kinds of things that you have just
claimed, that markets are irrational and that some single human being or
committee can determine prices better than the market. Statistical and
theoretical analysis DISCOUNTS specific cases by looking at appropriate
samples from the universe; it looks at large numbers. Laws of nature are
often untrue in small numbers. They need large numbers to be true.

The problems of East Asia were not caused by Soros, for example, but by
their own miserable form of crony capitalism. They are reforming now, in
some cases, building transparent institutions. They will emerge strong
and even more resplendent in the near future. We have not even dared to
trust the market; we don't even know our basic economics! Ignorance and
unscientific thinking is our greatest 'shield' from reality.  We have a
long way to go to reach where these SE nations, much worse off than us
just 50 years ago, are there today.

A million dollars waits patiently ... In fact if you suggest a method to
prove that markets are irrational and that planners are rational, then I
will help you by quitting IPI and working on this paper jointly. Maybe I
too will then share a Nobel Prize and the great glory of proving
capitalism to be a stupid system!!

Thanks,

Sanjeev


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