John Forman has a post regarding EMH, which ties into the recent discussions with regard to Gaussian distributions.

The question of whether the markets are efficient was broached again by a fellow blogger recently. The idea is that if the markets are efficient, then it’s not really worth attempting to trade them (meaning stock market investors should stick to index funds). This is all based on the Efficient Market Hypothesis (EMH).

There’s a bit of confusion in the public about what market efficiency really means. It does not mean that the price in the market reflects the value of the asset in question (like a company in the case of a stock). It means that current price reflects the array of potential future outcomes. Basically, the theory says that every idea of what could happen in the future is incorporated into the current price.

Actually I disagree. “Efficiency” means exactly that. That the “current market price” reflects the value of the asset.

With regard to the future, the future is unknown and unknowable. Thus, the market follows a “random walk” as new information is released to the market. Here is the catch, a “random walk” relies upon “independant observations.” The market however does not display independant observations, the market displays “dependant observations.”

Here’s my view.

The more actively traded a market is, the more it tends toward efficiency - especially in relatively low volatility and quiet news environments. Those are times when information can be distributed most efficiently and participants are most likely to act rationally. As you get into less actively traded markets, and as you start adding pressure to a market efficiency becomes less and less the case. Information distribution becomes less efficient and participants act increasingly less rationally.

Here we have a number of interesting problems. The first, measuring the “activity” of a market. Are we talking about the “number” of participants, or the volume of shares? Does it even matter which? Is the market consisting of a small handful of huge institutions the same as a market consisting of a huge number of more moderately sized participants?

Volatility and “news events” are linked, that this is causative seems to be implied. There is news every day. In fact the flow of news has expanded exponentially. How to assign causation to “relevant” or “important” news, in other words, separating out the noise.

Rationality and market participants are linked to a decreasing efficiency in distribution of information flow. An interesting hypothesis, however, this hypothesis is not pursued.