Keynes, clutch hitters, and the EMH

A few weeks back I did a post on a passage from Lords of Finance, trying to refute the widely held view that Keynes was a great investor.  I got some negative feedback from some commenters who knew more than I did.  But now I have completed the book, and feel even more strongly about this issue.  I’ll start with Keynes, but my real target is much bigger.

When analyzing someone’s investment skills it is important to put their results into context.  Any fool could have made money during the great bull market of 1928-29.  And Keynes was no fool, as this passage (pp. 338-39) clearly demonstrates:

He [Keynes] thought that the American central bank under Strong had done a remarkable job, a “triumph” he called it.  The Fed, while hiding behind the smoke screen of adhering to the gold standard, had managed very successfully to stabilize U.S. prices, and Keynes believed that with Strong at the helm, it could and would continue to do so.

But as 1928 progressed, his portfolio began to unravel.  He sustained substantial losses in April when rubber prices collapsed by 50 percent as the world cartel broke down, forcing him to liquidate large holdings to meet margin requirements.  The Fed’s tightening of early 1928 took Keynes by surprise.  After all, he argued. U.S. prices were stable and there was “nothing which could be called inflation yet in sight.”  In September 1928, with the Dow at 240, he circulated a short note among friends titled “Is there Inflation in the U.S.?” which predicted that “stocks would not slump severely [that is,]  . . . unless the market was discounting a business depression,” which the Fed “would do all in its power to avoid.”

.   .   .

Yeah, I recently made the same mistake.  But to continue . . .

The price for being a speculator was that all these miscalculations wrought havoc on his net worth.  By the middle of 1929, he had lost almost three-quarters of his money.  The only saving grace was that in order to meet his margin payments, he was forced to liquidate much of his stock portfolio and entered the turmoil of 1929 only modestly invested in the market.

Only someone as brilliant as Keynes could lose most of his fortune in the market of 1928-29.  Now I will admit that Keynes didn’t suffer big losses in the great bear market of 1929-32, but that was because he was forced to sell his stocks in 1929 to pay for the disastrous losses in 1928-29.  I’d call that luck.

Keynes did have one long period where he made a great deal of money.  How did he do it?

During the 1930s, Keynes’s speculative activities made him a rich man.  After losing 80 percent of his money when commodity prices collapsed after 1928, he had ended 1929 with a portfolio of under $40,000.  He shifted his strategy from short term speculation to long-term investment [emphasis added] and at the lows of the Depression put together a concentrated portfolio of a select number of British and American equities.  Convinced that Roosevelt would succeed in reviving the U.S. economy, Keynes used margin to leverage his portfolio by as much as two to one.  By 1936, his net worth was close to $2.5 million—the equivalent today of $30 million.  Though the bear market of 1937 more than halved this, by 1943 it had recovered to $2 million.  (pp. 490-91)

In other words buy and hold, don’t try to time the market.  Yes, you may lose a fortune in bear markets like 1937-38, but after all, even smart people can’t forecast the stock market.  And use a lot of leverage.  Of course as I pointed out in the previous Keynes post it helps if you have a rich backstop, no one would loan me millions to invest in the market.  And also invest during a strong bull market.  Keynes was lucky that stocks trended much higher after 1932.  Some might argue it was skill, but then why the “buy and hold” strategy?  Why didn’t Keynes bail out of stocks in 1937?

Far from refuting the efficient markets hypothesis (EMH), the story of Keynes’ investments actually supports the buy and hold recommendations of those who adhere to the efficient markets view, “stocks for the long run.” He did best when he didn’t try to time the market, and did poorly when he engaged in fancy speculative gambles during 1928-29.

Why do people have a mistaken impression of Keynes’ investment skills?  Lords of Finance has some clues.  On page 307 Ahamed makes this claim:

The great bear of Wall Street legend, Jesse Livermore, once observed that “stocks could be beat, but no one could beat the stock market.”

.   .   .

Livermore’s own career belied his own statement.  Sensing that the boom in 1907 was going to turn into a spectacular bust, he made his first millions by shorting the market just before the panic of that year.  He reputedly made another fortune the same way in 1929—he would make and lose several such fortunes in his lifetime.  In 1940 he shot himself in the cloakroom of the Sherry Netherlands Hotel in New York City.  He had $5 million in his bank account.

I did a double take when I first read this passage.  Doesn’t “belies” mean something like “contradicts?”  And yet can there be any more powerful evidence for the random nature of markets than this skilled investor making and losing a fortune several times?  And remember, this is someone famous precisely because he was such a skilled (read lucky) investor.  That’s all it takes to get famous on Wall Street; just winning a bit more often that you lose?  Then it must be harder to beat the market than even I thought.  I would have guessed that a “legendary” investor would have guessed right ten times in a row.

It seems to me that people must have some sort of cognitive illusion in this area.  They must see evidence of uncanny skill even where the rate of success hardly beats the law of averages.  And this reminded me of Bill James.

Bill James was a must read for anyone who was both a sports fan and an economist during the early 1980s.  I haven’t read him since, and I’m sure things have progressed greatly since I lost interest.  I’m hoping that commenters will fill me in.  For those who don’t know, Bill James wrote commentary on baseball that skillfully employed the same sort of statistical techniques that economists use.  Not only that, but he had excellent judgment; that sense (which can’t be taught) of what data is meaningful and what is not.  He used simple statistical tools, leaving fancy “regression” techniques for others.  He was open-minded.  He was an excellent writer.  Over time his writing style became more colorful, with lots of little essays.  In other words he was a first rate blogger a decade before the internet.

James demolished many long-cherished theories about baseball.  I recall that he showed that teams that were “clutch” (i.e. winning the close games) were actually “lucky.”  He did this by getting a predicted win/loss record based on total points scored and given up, and then compared it to the actual win/loss record.  Teams that overachieved one year, tended to revert back the following year to the win/loss record predicted by the formula.

All of us sports fans see all sorts of “patterns” that we think are correct.  Players have hot streaks, certain hitters or teams are “clutch,” great pitchers get better with age, etc.  And James showed most of these were just hogwash, or more politely what I call cognitive illusions.  What I find interesting about all this is that these illusions are almost identical to the sort of faulty thinking that led people to think Keynes and Livermore were great investors.  Seeing patterns where there are no patterns.  James showed that sports fans routinely engage in exactly the sort of thinking that would lead someone to falsely reject the EMH, even if the EMH was true.

So who are you going to believe?  Me or your lying mind?



37 Responses to “Keynes, clutch hitters, and the EMH”

  1. Gravatar of Rob Rob
    19. July 2009 at 18:26

    Scott, I’m going to believe my lying mind as always. It’s DUE to tell me the truth for a change.

    I don’t know if I really believe in the EMH or not. I guess the main reason I’m inclined to believe it isn’t all luck is because of the fact that investors such as Soros or Jim Rogers aren’t merely successful, but also extremely intelligent. If success all amounts to luck the odds would be just as great that the billionaires would be illiterate idiots, wouldn’t they?

    Bill James now works for the Red Sox, hired by their billionaire commodity trader owner. Coincidence? Just as many of James’s beliefs have changed the game of baseball, a parallel change has taken place in stock trading. Sure, there is still the para-science popularized in trading get-rich-quick seminars, which promote reading chart patterns, etc. (But there are still some baseball managers who still think bunting is a good idea too.) But there is also the statistical inference group, who employ the scientific method: forming hypothesis, testing them (not data-mining). Vic Niederhoffer perhaps pioneered this rigorous approach, although he has proved to be a blow-up artist himself. (I think he just took ridiculous risks.) I believe he still has his sprawling estate and is better off than Livermore ended up.

    Wasn’t Niederhoffer a University of Chicago guy? Wasn’t he the black sheep?

  2. Gravatar of HB HB
    20. July 2009 at 02:26


    Keep in mind that it usually requires intelligence to gain access to the large sums of capital necessary to generate large-enough returns to get noticed by the investor community. In other words, without a college degree from a reputable university, most money-management firms will not hire you and thus your access to institutional investor-sized capital is limited.

  3. Gravatar of ssumner ssumner
    20. July 2009 at 04:40

    Rob, I’m afraid I don’t follow the investment industry very closely, and don’t know who Niederhoffer is. Your Bill James comment raises an interesting point. If the James technique proved so effective in Boston (and also Oakland?) doesn’t that suggest baseball strategy was not an “efficient market” before James arrived?

    I don’t know what to say about billionaires. Many do much more than simply through darts at paper. They are often entrepreneurs and managers as well. That requires intelligence. In addition, it is hard to get that rich without making leveraged investments in highly volatile markets like currencies. I wouldn’t even know how to raise the money, where to go, how to structure complex arbitrage set-ups, etc. But I don’t want to be dogmatic about this, I think the top people probably are slightly smarter at investments, just not enough to make markets very inefficient. The analogy is that I think players like Kobe and MJ probably were slightly better in the clutch, just not enough to show up in broad tests of “clutch performance” for the whole league.

    Nobody has taken me up on a test I proposed earlier. Once people become billionaires does their average rate of return still beat the market? The EMH says no. The anti-EMH says yes. It should be testable.

    HB, I should have read your answer before typing my own. We think along similar lines. But again, I don’t want to completely dismiss Rob’s point, there may be a bit of truth to it.

  4. Gravatar of Oscar Oscar
    20. July 2009 at 04:43


    I think your view on the EMH contradicts many of your other views. Take the following examples:

    Situation 1:
    Person A (US resident)takes the advice of Eugene Fama (It took a lot of effort not to throw in an insult), and invests in an index tracking fund in 1991. They look at their returns in 2009 and they have made money, but after adjusting for inflation not that much, and the chance of them not losing their nerve somewhere in between is slim.

    Person B (Japanese resident) takes the advice of Eugene Fama and invests in a index tracking fund of Japanese stocks, believing that stocks for the long run is the way forward. Oh dear. They look in 2009 to find they have 20 cents on the dollar.

    So much for buy and hold.

    Situation 2:
    Person A and Person B consider he effect of inflation/deflation before listening to Fama.

    It is not clear what effect that would have had on Person A, but IT SURE WOULD HAVE SAVED PERSON B A LOT OF MONEY!

    I don’t think I will be doing any buying and holding, because I believe deflation will be disastrous for equities, equally if the Fed makes one big push, I will be long those inflation susceptible assets.

    Most investors are lucky. ABSOLUTELY NO DOUBT ABOUT THAT, and they are the ones that produce spectacular gains and losses. But being thoughtful and cautious, and thinking deeply and logically about the enviroment in which you operate is not lucky.

  5. Gravatar of Van Van
    20. July 2009 at 07:54

    HB, “In other words, without a college degree from a reputable university, most money-management firms will not hire you and thus your access to institutional investor-sized capital is limited.” not sure what this means…I didnt go to Princeton undergrad or Harvard B-School. But i managed to become a bond trader for the largest, most recognized fund manager in the universe – and i wholly expect to rise further. not sure exactly what the connection is to access to capital. not picking a fight, just trying to understand…

  6. Gravatar of Thruth Thruth
    20. July 2009 at 08:40

    “I would have guessed that a “legendary” investor would have guessed right ten times in a row.”

    This happens once you get a cult following on the Street, folks who will gladly follow your trades. It’s kinda like being the house at that point.

  7. Gravatar of Phil P Phil P
    20. July 2009 at 08:59

    Scott, you think Keynes and Livermore were not great investors because they made and lost fortunes several times. I think I would have settled for making a fortune just once; even if I lost it later it would have been fun while it lasted. And $5 million in 1940 wasn’t chopped liver.

  8. Gravatar of azmyth azmyth
    20. July 2009 at 09:14

    Scott – “doesn’t that suggest baseball strategy was not an “efficient market” before James arrived?”
    I think that people are always discovering new patterns, but once they tell people about it, the pattern will disappear. Market prices are not about perfection, but about aggregating information. Baseball was efficient before and after, but there is always more information to add and more patterns to find (and destroy). I agree that people underestimate randomness and are fooled by selection biases.

  9. Gravatar of Keynes and the efficient markets hypothesis Keynes and the efficient markets hypothesis
    20. July 2009 at 09:18

    […] at The Money Illusion, Scott Sumner, has posted a number of blog entries about John Maynard Keynes as an investor and how it informs the debate about efficient […]

  10. Gravatar of Oscar Oscar
    20. July 2009 at 09:41


    You are referring to Goodheart’s law.

    Scott do you feel that Goodheart’s law would kill your NGDP futures market targetting?

  11. Gravatar of Bababooey Bababooey
    20. July 2009 at 10:20

    I usually just read, but felt forced to mention that Earl Weaver has already put into successful practice many of the things Bill James was wondering about to himself in the 1980s. Weaver arrived at his conclusions through the simple observation that each team has 27 outs and the worst thing to do is relinquish one. That first principle lead him to eschew sacrifices and value on base percentage, as you can read in his excellent “Weaver on Strategy”. (This is not to deny James his wonderfulness, but to grant Weaver his due and note that Weaver risked his job on his nontraditional beliefs.)

    (You can also sample Weaver’s profane sense of humor by searching “Earl Weaver Manager’s Corner”.)

    Also, because jargon is so important to you economists, baseball teams don’t score points, they score runs and the term generally used to describe a team’s hypothetical record based on runs scored and allowed is “Pythagorean Record.”

  12. Gravatar of Current Current
    20. July 2009 at 10:28

    Goodhart’s law, the Douglas Adam theory of monetary policy:
    “There is a theory which states that if ever anyone discovers exactly what the Universe is for and why it is here, it will instantly disappear and be replaced by something even more bizarrely inexplicable. There is another theory which states that this has already happened.”

    However, this idea doesn’t really have very solid foundations. I quote a witticism to describe it, but it is a bit of a witticism. There are theories out there that if implemented we have good reasons to think won’t change the problems in an unpredictable way.

  13. Gravatar of Jim Glass Jim Glass
    20. July 2009 at 10:37

    … doesn’t that suggest baseball strategy was not an “efficient market” before James arrived?

    The exact premise of “Moneyball” and how Billy Beane managed to get the As into the playoffs year-after-year with a budget far lower than average. Of course, innovations are copied and spread, and so it’s been with his.

    Businesses, markets are always inefficient against an ideal, which is why they always evolve and “advance”.

    Before Babe Ruth, baseball was inefficiently “small ball” — as James pointed out, Ruth’s homers resulted from a revolutionary technique change with his swing, as evidenced by how the new much-higher homer totals spread over several years first from him to his Yankee teammates, then to other teams in the AL team-by-team, then to the NL. (If the homers had resulted from a newly juiced ball, as is a common belief, homer totals would have gone up everywhere at the same time).

    Before Jackie Robinson, baseball inefficiently excluded black players, then the Dodgers got a big advantage by signing them, then other teams copied the practice team-by-team… So it goes ….

    BTW, James graduated college with an economics degree but couldn’t get a job with it, and was working as a night watchman at a pork-and-beans factory when he started writing his baseball abstracts. There’s a lesson in there somewhere.

  14. Gravatar of Jim Glass Jim Glass
    20. July 2009 at 10:42

    Keynes, IIRC, not only covnerted himself from a daring speculator to a buy-and-hold guy, but to a guy who specialized in buying and holding the safest, high-dividend paying utlility stocks. He’d learned his lesson.

    (And maybe also took advantage of the regulated “monopoly” positions of the utilities he bought? Warrren Buffett would apprecaite that.)

  15. Gravatar of Jim Glass Jim Glass
    20. July 2009 at 13:20

    “So much for buy and hold.”

    Why? Buy and hold doesn’t guarantee you will make money from time period 1 to 2. Nor does EMH. Nor does anything else.

    Buy-and-hold helps returns two ways: (1) It minimizes transaction costs, & (2) it prevents you from making timing mistakes.

    #1’s value should be obvious, if you knock from 0.5% to a couple points per year (or much more via repeated trading fees) off your return due to transaction costs, when stocks on average return about 6% real, bonds less, you are killing yourself.

    E.g. for mutual funds, S&P recently reported that index funds continue to clobber [.pdf]] actively managed mutual funds, showing that for mutual funds the benefit of active management is too small to be worth the price.

    (Maybe you’d be much better at managing investments than 80% of professional mutual fund managers, but how would you know that beforehand?)

    #2 is often overlooked, because everyone is so smart they think they can at least pick market ups and downs, but it may be even more important.

    Multiple studies show that during the boom market stretches of the last 25 years, even as murual funds zoomed up in value the average investors in them did much worse — or lost money outright in rising funds — because they chase the market. I.e., after it rises enough for them to be sure it is rising they get in, then after it falls enough for them to be convinced it is falling they get out, so they trade missing some (or all) or the rise in exchange for catching some (or all) of the fall, thus doing way worse than the fund itself.

    Compound #1 by #2 and you need to have a heck of a lot of skill as a timer to overcome the fees and risks of going into and out of the market with anything but a lot of luck. And if you are investing in individual stocks or bonds, there’s another level of compounding.

    (As an anecdote, I got a personal “sell” signal near the end of the 1990s boom market during a dinner I had with a then-noted manager for a high-flying fund group that shall remain nameless here, two-faced as it was, who was in town to appear on Rukeyser’s Wall Street Week the next day. Making nice I said: “Gee, you have a difficult job. You have to not only pick when the market is going to go up and down, but you also have to pick when individual stocks within the market will go up and down too, that demands compounded foresight!” He looked at me and said, “You know, you’re right, I never thought of it that way”. I sold my shares in that fund and it saved me a chunk.)

    Situation 2: Person A and Person B consider he effect of inflation/deflation before listening to Fama. It is not clear what effect that would have had on Person A, but IT SURE WOULD HAVE SAVED PERSON B A LOT OF MONEY!

    That would be if Person B has done his considering in 1991 with the help of a functioning crystal ball that told him how different inflation would be during the future 18 years than it was during the previous 18 years, and in which direction.

    But the EMH expressly prohibits use of functioning crystal balls.

    As far as investors are concerned, the EMH doesn’t say the market is always right, nor that you can’t beat the market (Soros, Rogers, Buffett etc,) and certainly not that looking backward with hindsight one couldn’t find investments that would have beaten an index fund.

    What it says is that going forward you can’t systematically beat the market by using publicly available information, because after all the whole public has it, which would mean the public would have to be able to systematically beat itself.

    Note this does nor prevent, say, Warren Buffett from systematically beating the market. He hasn’t made his money by picking stocks out of the WSJ listings, like Hillary said she picked her cattle futures.

    He’s made it from building an operating business (superior business management skill) which happens to be an insurance company, which generates large free cash flow, which holds investments in a highly tax-favored manner (compounding!), which are purchased at significant discounts and with lower transaction costs than are available to others (because he is Warren Buffett [TM]). Plus it’s a fair bet that Buffett occasionally possesses information not available to the general public. And nothing about the EMH says one can’t beat the market systematically with that asset set.

    investors such as Soros or Jim Rogers aren’t merely successful, but also extremely intelligent..

    One might consider that they have asset sets comparable to Buffett. And/or consider that the EMH is entirely consistent with a percentage of investors beating the market very impressively for a good long time before regression to the mean snags them back … say: “Bill Miller.”

    If success all amounts to luck the odds would be just as great that the billionaires would be illiterate idiots, wouldn’t they?

    No chance. It’s called “Red Queen competition”. The best compete like all get-out making the best use of the information available to them to stay even with each other. But if none of the best have any systematic or information advantage over the others, none of the best can get ahead of the other best except by chance. However, if newbies enter the game not knowing the rules or what to do, they get slaughtered immediately.

    The Nobel physicist Richard Feynman used to tell a story about meeting the famous gambler “Nick the Greek” in Vegas (not the disgraced TV football tout Jimmy the Greek). Feynman said to him: I know a little bit about probabilities and I don’t understand how you can make such a good living beating the house out here. The Greek told him: I don’t beat the house, I beat the people who come here thinking they are smart enough to beat the house.

  16. Gravatar of Rob Rob
    20. July 2009 at 14:19

    “it is hard to get that rich without making leveraged investments in highly volatile markets like currencies. I wouldn’t even know how to raise the money, where to go, how to structure complex arbitrage set-ups, etc.”

    I’m going to quibble that it takes almost zero intelligence to gain access to trading currencies with 20X leverage. Click on any Forex ad. Any fool could be a Soros in theory. Go read the comments on any commodity traders forum and you will get an idea of the average literacy level. Currency markets are extremely non-prejudicial: your resume will not help you earn one penny. So the fact that the most successful currency trader ever was a student of Karl Popper’s, has published clever philosophical essays in the Atlantic, and authored the very well-wrought book, The Alchemy of Finance (whatever one may think of his ideas)””seems much more than a coincidence. But it could be.

    “But I don’t want to be dogmatic about this, I think the top people probably are slightly smarter at investments, just not enough to make markets very inefficient.”

    This begs the question: If the market can always be slightly more efficient, what does it mean to say it is efficient at all? Relative to what? Once you back away from the purist view even slightly, what is the EMH worth? Because no one is claiming that beating the market over the long term isn’t extremely difficult (Except for those charging big dollars to attend seminars on it, writing popular books about it and advertising their courses and software on CNBC…. OK: I guess a lot of people are claiming it is easy. But obvious conmen don’t count.)

  17. Gravatar of Rob Rob
    20. July 2009 at 14:37


    “if newbies enter the game not knowing the rules or what to do, they get slaughtered immediately.”

    If newbies do worse than than anyone else, it rejects the EMH just as adamantly as saying that more powerful traders are more likely to beat markets. (Even with under-capitalization, newbies should perform no worse as a group.)

  18. Gravatar of Laeeth Laeeth
    20. July 2009 at 14:56

    “That’s all it takes to get famous on Wall Street; just winning a bit more often that you lose?”
    Precisely – money management is one of the toughest aspects of the investing process. If you can be consistently right 51% of the time and invest only with 3:1 risk:reward in your favour you will be on your way to being one of the strongest investors out there. Easier said than done, of course.

    ” I would have guessed that a “legendary” investor would have guessed right ten times in a row.”
    Ha ha ha. I enjoy reading your blog, but statements such as this are one of the reasons that very few practitioners care very much for the opinions of most economists. The game isn’t about being right – it’s about making money, which is something entirely different. Presumably, by that yardstick, a ‘legendary’ applied macro economist would have called ten turns in the business cycle correctly? (Rather than a more typical zero).

    It has to be said that the emotional aspect of investing and trading (particularly the latter, where leverage and a shorter time horizon) can be the most difficult aspect and one that makes it hard to maintain performance over decades. It is difficult to separate what is going on in one’s personal life completely from one’s professional life. Livermore made some unfortunate decisions in his choice of partners – his wife shot their son in a drunken rage. I imagine that might take its toll on one’s judgement. The nature of the markets also changed in the postwar era and it seems that Livermore’s approach was less adapted to this new regime.

    Livermore was obviously not trying to earn the 15-20% an aggressive institutional investor might target in our time, but rather swinging from the fences, trying to compound his capital by multiples over the years (he started with nothing). That obviously corresponds to a much higher risk of ruin and much nastier drawdowns. Still despite all the upheaval in his personal life, to leave $5mm at that time is nothing to be sniffed at.

  19. Gravatar of Jim Glass Jim Glass
    20. July 2009 at 15:49

    “if newbies enter the game not knowing the rules or what to do, they get slaughtered immediately.”

    “If newbies do worse than than anyone else, it rejects the EMH just as adamantly as saying that more powerful traders are more likely to beat markets.”

    Really? The EMH says that people acting very smartly can’t use publicly available information to systematically beat market returns.

    Does it really say people acting stupidly can’t do worse? Go bust?

    If, say, they don’t consider all publicly available information? E.g., there’ve been stories in the financial pages in the last few days of people still trading GM stock — the stock of the *old* GM that no longer exists, as a result of confusing it with the new GM.

    (The SEC even issued a release on it: “The SEC and FINRA are issuing this Alert because we believe there may be widespread misunderstanding by investors that stock in the ‘old’ General Motors Corp (now known as Motors Liquidation Company) is related to the ‘new General Motors Company.'”)

    So does the low return that comes from being a dumbbutt who invests in the old GM thinking it is the new GM really violate the EMH?

    “Market returns” are not “random returns”. If they were, then the original point that lucky dumbbutts are under-represented in the Buffett-Soros-Rogers class of self-made billionaire investors would indeed be a challenge to the EMH, but I’ve never seen anyone raise that challenge.

    “(Even with under-capitalization, newbies should perform no worse as a group.)”

    Well, maybe you are thinking in terms of newbies who show up at the Vegas craps tables and bet everthing they own on one throw of the dice to come up snake eyes, and lose and get wiped out, peforming no worse than anyone else as a group because they get the same return from the dice as everyone else.

    Except they are exterminated, out of the game, when the first objective is to stay in the game. And the percentage of them that are lucky enough to win (1/36) will probably be eliminated soon enough, after repeating such dumbuttedness (being encouraged to by their success!).

    So when they are eliminated from the game their return is what? And their return as a group is affected how?

    When you hit the floor, lack of capitalization drops all future returns to 0, unless like Keynes you have someone like Dad to bail you out.

  20. Gravatar of Rob Rob
    20. July 2009 at 16:36


    Think about it. As a group, newbies are well-capitalized and well-diversified. If they under-perform the market then, as a group, everyone else must out-perform the market. “People acting smartly using publicly available information” are a subset of “everyone else”. So if you divide “everyone else” into two groups: “people acting smartly etc.” and “the others” one of those two groups must out-perform the market. If according to the EMH “people acting smartly etc.” cannot out-perform the market, that only leaves “the others”. Then, according to the EMH, “the others”, this very mysterious group — is who you want to invest your money with…

  21. Gravatar of rob rob
    20. July 2009 at 19:06

    put another way: if u knew the newbies investment decisions would reliably underperform, the key to beating the market would be in knowing what thw newbies would do and arbitraging the difference. wait. now i think im defending the EMH. how did that happen?

  22. Gravatar of Jim Glass Jim Glass
    20. July 2009 at 21:05

    “As a group, newbies are well-capitalized and well-diversified.”

    Except they invest as individuals, often not well capitalized and routinely under-diversified (practically a working definition of newbie) which leaves them subject to being ejected from the market by force, necessity, or unwillingness to bear more pain.

    How does that affect their returns?

    “if u knew the newbies investment decisions would reliably underperform, the key to beating the market would be in knowing what thw newbies would do and arbitraging the difference.”

    Assuming that you had the information available to you to do that (there are countless ways to beat the market assuming you have information you don’t have and that’s not publicly available) and also in particular that newbies stayed in the market so you could arbitrage their market actions.

    But remember another classic trait of newbies is “chasing the market”, getting out inefficiently.

    Take a market that gains say 20% after a series of ups and downs over a period of time, and assume it is efficient and all so that the best one can do on a risk-adjusted basis is that 20%. (You can certainly try to get more by adding risk by levering up or investing in only part of the market, but you can’t get a better risk-adjusted return).

    Now say the newbies do the empirically demonstrated factually true thing they actually do on a mass scale — try to market time by “chasing the market”, so they trade being out during part (or all) of upswings for being in during part (or all) of downswings, so they earn a much lower return than provided by the investments they invest in to those who stay fully invested.

    They earn less than the market, but that doesn’t mean anyone else can earn more.

    How would you arbitrage them “chasing the market”? You’d have to time the market yourself. How? With a crystal ball that predicts for you true market turns? (Not sold to newbies?) Unlikely.

    You’d have to try to identify when they are selling and buy then (or buy more, levering up) and identify when they are buying and sell then.

    It’s a known strategy, but it’s also known not to work because there’s not much of an identifiable pattern in stock timers being wrong (only in being right), error is sort of random, and any attempt to follow peaking volume (“I’ll buy only when their selling peaks”) has the problem of one not being able to identify a peak until after the fact, which results in … chasing the market. (Plus there’s all the transaction costs of going in and out you have to cover.) I.e., the information needed to make the strategy work isn’t available.

    Which leaves one much better off staying in the market full-time and settling for the optimum 20% risk-adjusted, no more.

    It might be useful to keep in mind the difference between investments and investors. Investments can be efficiently related to each other on risk-return basis so that even “old GM” stock fits in rationally somewhere.

    But even as they are so, individual investors in them can stupidly take on too much risk with too little capitalization knocking their return down to “-100%, permanent”, and make stupid in-and-out timing decisions that reduce their return to below the those provided by their investments (such as the entire classes of mutual fund investors who have literally lost money while mutual funds have risen in value).

    That is, the fact that investors can be irrational and inefficient doesn’t at all prove that markets are. It’s been shown by Becker and others that markets can be rational even when participants in them are totally non-cognizant random actors.

    But I’ll let you have the last word on this, since this stuff can go round-and-round, and it doesn’t really seem the subject of this blog.

    I’ll just add this one thought: the refutation of the EMH as far as investors are concerned, “it’s not possible to systematically beat the market using publicly available information” is not in academic arguments like this, or the existence of Warren Buffett, or big market swings or any other such thing.

    It is in actually having a way to systematically beat the market using publicly available information!

    If you have that way, tell the world — there’s no reason to keep it quiet, it’s all already known to the public. Don’t be a negative nabob saying bad things about the EMH which don’t really prove anything. Be positive and tell all the superior way to invest for higher-than-market return, at reduced risk, that refutes the EMH.

  23. Gravatar of Rob Rob
    20. July 2009 at 22:44

    Did we really land on the moon? Doesn’t the EMH reject it?

    Why is it so crazy to think some investors are better than others?

    It is so easy to argue against the EMH. Can someone please give one good argument for it?

    Anyone? Anyone? How about you, Ferris?

  24. Gravatar of ssumner ssumner
    21. July 2009 at 04:34

    Oscar, The Japanese example shows why there is an equity premium, you do risk losing a lot of money as stocks are riskier than bonds. But I don’t think people knew, ex ante, that Japanese stocks would do poorly. I agree that if people could figure out, ex ante, which markets would do poorly, then they would not want to buy and hold, but I don’t think they can. Remember that it is always easy to look backward and figure out better strategies, I am kicking myself for not selling last summer, but I thought the Fed would keep targeting inflation and not go into deflation.

    Phil P. My point is all about the EMH. They’re records are claimed to “belie” the view that it is hard to beat the market, but they actually show it is very hard. If even these undeniably smart and successful investors frequently lost their shirt, how can anyone say a stock markets is “obviously” over or undervalued when Shiller’s formula says it is. Remember that Livermore was famous precisely because he was successful. And even he was often wrong. That is exactly what you’d get if the EMH was true, and some individuals were luckier than others.

    azmyth, I agree. Although it could be argued that baseball teams were slow to catch on. I know little about baseball, but when I read James in 1981 It was obvious that he was right. Some managers understood his ideas even then (such as Earl Weaver) but many did not.

    Oscar, See answer to Current below.

    bababooey, Yes, I just mentioned that point. I recall he favored sluggers with high OBPs.

    I don’t know why I said points. You can tell it has been a long time since I followed baseball, but I did know that.

    Current, Now I remember Goodhart’s Law. No it doesn’t affect my argument, as I am not basing the proposal on the observed correlation between NGDP futures and actual NGDP. There are no NGDP futures today.

    Jim Glass, Thanks for the babe Ruth anecdote. I have never viewed the EMH as perfectly true, but rather a useful model. I deny that the anti-EMH can help us regulate the economy, or can provide me with useful investment advice. I find it amusing how many people like to buy stocks when they are soaring, and sell when they get discouraged. I am just the opposite. Like the atheist who is good just in case there is a heaven, I sometimes follow Shiller just in case he is right. After all, the EMH says I have nothing to lose. So I prefer to buy after a market has crashed, and vice versa. I tell people there are two possibilities:

    1. The markets are efficient, and you should never sell because you are discouraged.
    2. Shiller is right, and you should buy when you are most discouraged.

    Either way what “you” (not you Jim, but my hypothetical person) have just told me is stupid.

    Does that make sense?

    Rob, I addressed your question in my earlier post on Rorty and the EMH. I argued that the anti-EMH had no practical implications, and hence was worthless. I pointed out that if federal regulators were as smart as George Soros, the anti-EMH position might be useful for government regulation, but they aren’t. And I also pointed out that mutual fund success is not serially correlated, so we also know that the people managing those funds are not like George Soros.

    Earlier someone discussed Babe Ruth’s hitting style innovation, which was then copied. I think it is possible the Soros invented some new technique, that was later incorporated into the market. But to answer you question about what does the EMH mean, I’ll first tell you what it doesn’t mean:

    1. The EMH is not to be used in empty debates about whether this or that person can beat the market. Rather, the EMH has usefulness, it helps us understand all sorts of things about markets, such as why new information is immediately incorporated into asset prices.

    2. The anti-EMH position has no useful information. It doesn’t tell the government how to regulate, and it doesn’t tell an investor like me where to invest.

    Your George Soros story is completely consistent with point 1, and doesn’t change the conclusion in point 2 at all.

    Laeeth, You misunderstood my point. I agree that it is hard to consistently beat the market more than 51% of the time, but at the some time some people will be right 10 times in a row based on luck. If they have been aggressive investors, they can easily become rich. If not, then they won’t become rich. I once won 12 blackjacks hands in a row, but I didn’t “invest” enough to become rich. I understand that point.

    You said:

    “The nature of the markets also changed in the postwar era and it seems that Livermore’s approach was less adapted to this new regime.”

    That’s possible, but isn’t it far more likely that his luck simply ran out. It must be really frustrating to discover late in life that your success was just luck.

    Rob, I gave you one. Your theory predicts mutual fund returns are serial correlated, and they aren’t. That proves variations in mutual fund returns are luck, not skill.

    I do agree with you on the stupid investors though, they shouldn’t lose much on average.

  25. Gravatar of rob rob
    21. July 2009 at 17:30

    thanks, scott. im not trying to be stubborn, just trying to understand. we are all getting a top notch education for free here, after. i didnt learn nearly as much in the few economics classes i took in college.

    i guess part of my point about soros, as yet unsaid, is that he makes a big deal in his alchemy of finance book that he doesnt believe in the emh. his babe ruth swing, so to speak, he claims, is his belief that the market has feedback loops. he claims his success has been in identifying asset bubbles and riding them up and then down. for instance, he made a lot shorting oil in the 80s while buying the s&p, shorting the pound in 92, asia in 97, shorting the s&p last year, etc. but as u point out, perhaps his anti emh position is mainly only relevant to him! although when he claimed in his book at the start of 08 he was short the US (but long china) i followed his lead on the US. i didnt on china because rogers (a big long term china bull) emailed me back he thought china had risen too far too fast. all my investment decisions so far has been based on trying to follow the advise of those whose arguments seem the most compelling, and so far that has worked.

    right now, u strike me as the most compelling voice, so i am starting to rethink bu
    y and ho,d. thanks for your amazing patience and great posts.

  26. Gravatar of Jon Jon
    21. July 2009 at 18:08

    Regarding the EMH: I think a critical point in asset markets is to understand the role of marginal pricing. A few smart and well informed people can move the price because ‘they are the margin’–they make a coordinate action against a background of noise.

    I think that there are certainly situations though were the dumb money moves to overwhelm the volume. Whenever the dumb money moves uniformly rather than being a background of random noise they become the margin.

    In this sense, ‘buy and hold’ by the masses is socially beneficial whereas day-trading is not. For these reasons I think it is less than a coincidence that many of the great bubble markets coincided with suddenly large pools of neophyte traders. We saw this during the Tech bubble’s day trading boom. We saw this in the late 20s as everyone rushed to get in on the market. We saw this in the past few years too in the Stock Market. We saw this during the tulip craze. We saw this during the housing run-up.

    Whenever I hear random neighbors and friends speaking the same investment idea, I take that a clue to do the opposite.

  27. Gravatar of ssumner ssumner
    22. July 2009 at 05:31

    rob, I don’t always use the EMH when investing. Life’s to short, so you have to have some sense of adventure. I made a good call selling all my Asia funds in late 2007, and followed that with a bad call of going back in at modestly lower levels in 2008. Then they crashed. You win some and you lose some.

    Thanks for the comment on my blog.

    I also like the contrarian strategy. That’s why I say that if one is going to go against the EMH, go with the Shiller view. But most people I talk to are just the opposite. They sell stocks after the stocks have crashed, because they are frustrated.

  28. Gravatar of ssumner ssumner
    23. July 2009 at 05:30

    Jon, My second paragraph to rob was actually responding to you.

  29. Gravatar of keynes: Bursting The Myth of Keynes As a Genius Investor keynes: Bursting The Myth of Keynes As a Genius Investor
    24. July 2009 at 11:36

    […] of the great myths of economics is the myth of Keynes as an unerring investor of genius.  In fact, Keynes had a very rich daddy who bailed him out whenever he got himself in financial trouble, and Keynes even managed to loose tons of money in the […]

  30. Gravatar of Greg Ransom Greg Ransom
    24. July 2009 at 13:57

    Keynes most important investment portfolio was an endowment fund at King College, which is examined here:

  31. Gravatar of ssumner ssumner
    24. July 2009 at 17:33

    Greg, Thanks. Tell me if I am reading figure 7 correctly. Keynes massively outperformed the UK index in 1934-36, but closely tracked it otherwise during the period from 1924-1946. Is that right? (I am referring to the black line.) The book I read said he took a highly leveraged gamble on equities in 1933, based on the assumption that FDR would boost AD. Looks like a good bet. But otherwise he was an average investor.

  32. Gravatar of Current Current
    30. July 2009 at 01:15

    There is a story, which may be myth that the reasons Keynes did so well in the mid-30s was insider information. Specifically, he knew about when the US government would perform gold purchases from economists associated with the government.

    This may just be a vicious rumour though.

  33. Gravatar of ssumner ssumner
    30. July 2009 at 04:45

    Current, That’s interesting. Does Skidelsky take a position on this theory in his book?

  34. Gravatar of Current Current
    30. July 2009 at 05:02

    Scott: “Does Skidelsky take a position on this theory in his book?”

    I don’t know because I haven’t read Skidelsky’s book. It’s a dirty rumour I heard on the internet. I can’t find the source right now though. I’ll post again if I can.

  35. Gravatar of Mike Sandifer Mike Sandifer
    4. September 2009 at 23:07

    Problems with Strong Versions of EMH from a non-economist:

    1.) If this approach is so rational and well-supported, then why do so many reject it, at least implicitly and try in vain to beat the market? Does this suppose that a market can be relatively more rational in the aggregate than at the micro level?

    2.) Today, with the influence of large, institutional investors, I’d think there are opportunities for smaller investors who can invest and divest much more nimbly.

    3.) As Milton Friedman argued, if strong versions of EMH led even the brightest stock pickers to fail to beat the market on average, might this not cause many of them to give up and do other things? Then, markets might become even less efficient, again providing more opportunities for more talented investors such that a cycle occurs.

    4.) Non-financial risk aversion (in 80% of any large population) and emotional decision-making at times, even if rarely, favor implicit memory system processing, which relies on more well-established learning and instincts, many of which are antithetical to rational analysis. Known personality differences, such as those with risk-neutral or risk-seeking behavior can then outperform the broader market.

    5.) Of course, insider trading and market manipulation may undermine the strength of EMH.

    6.) Markets have natural incentives to form bubbles and create temporary, but consequential disequilibria, as most participants benefit handsomely from booms.

    7.) Mimickry of trading strategies is not as straight-forward or as successful as some strong EMH adherents claim. Teh brain faces vast numbers of permutations at every stage of decision making to work from one stage to the next in successfully completing a task. A former investment banking employee who was charged with teaching trading strategies to what he describes as very bright traders said his training failed to take hold. Old, suboptimal habits and instincts could not be eradicated. There is a link to a discussion is which he discusses this in the context of neuroeconomics:

    8.) Investors employ a large number of different trading strategies, which is related to the permutation problem mentioned above, many of which are dubious at best, even with respect to large investors. How does one come to the conclusion that a market with such heterogenous approaches happens to be more efficient than any traders or investors on average?

    9.) EMH is not testable in the most rigorous sense and the same data, as in much of economics, can be interpreted in diametrically opposing ways.

    10.) Some strong EMh adherents have de-empasized even fundamental analysis, trusting markets to get valuations as close to correct as currently possible, even when the fundamentals versus the market are clearly out of whack, as is the case with bubbles.

    11.) What about problems of assumptions of normality in the distributions of stock prices? What about fat tails?

    12.) How does one overcome the fact that if many investors adopt buy and hold strategies, it leaves more opportunities for short-term traders, especially during booms in which even apes throwing darts can pick short-term winners more often than losers? During the last boom, I was often long, as the risk/reward was great. Even if I lost out on 70% of my positions, I could still profit handsomely, and beat the markets by a long, long shot. Sure, maybe I was just lucky, on a long thin tail, but this wasn’t uncommon among those I knew, anyway.

    13.) Trading without a sound macroecnomic context can be disasterous, and yet even many professional economists don’t seem to understand macroeconomics that well. Just look at Krugman on old Keynesians, the number of liquidationists out there, and those like Feldstein who don’t understand that interest rates don’t rise when government borrowing doesn’t exceed the collapse in private borrowing.

    14.) There are always opportunities for at least short-term arbitrage, allowing some to make supernormal profits.

    15.) Agent-principal problems abound.

    16.) There often aren’t incentives for good investment performance from securities brokers, as profits depend on transaction volumes and in some cases, pump and dump strategies.

    17.) Portfolio distributions are often influenced by emotional considerations other than financial ones, leading to suboptimal results and opportunities for sounder investors.

    18.) Other explanations can account for observations, such as that 70% or more of professional money managers fail to consistently beat markets over the long term. These include some items mentioned above, along with the complexity of markets and sometimes vastly different approaches to dealing with uncertainty, often without the use of explicit models such as CAPM and its related successors.

    19.) Even if all information taken into account by the market increases its effiency, the proliferation of it is uneven and thre are often large amounts of information missed by te majority, but exploited by a minority of investors. These are dynamic opportunties that once missed, cannot be mimicked, as opportunities dry up before competition heats up/

    I think I have some more potential problems with strong EMH theories, but it’s too late to finish now. Perhaps I’ll add some more later.

  36. Gravatar of ssumner ssumner
    9. September 2009 at 01:29

    Mike, I don’t have time to answer all or your questions, nor do I believe in the strong EMH. So I’ll just pick a few. Your question about why do so many people try to beat the market makes no sense. Obviously the average investor cannot beat the market by definition, so refering to what the typical investor does can hardly be an argument against the EMH. Even the anti-EMH types agree the average guy can’t beat the market.

    Fat tails have no implications for the EMH, nor does the principal-agent problem

  37. Gravatar of ssumner ssumner
    9. September 2009 at 02:02

    Mike, Regarding points 6 and 12; I don’t understand how the fact that many people make a lot of money during booms counts against the EMH. It seems to me that that fact is a prediction of the EMH. Regarding point 13, the fact that macro outcomes are hard to predict does not in any way count against the EMH. Investors do the best that can, and often that is not very good. BTW, I don’t whether Feldstein doesn’t understand the argument you just stated.

    The EMH has been extremely useful to me in my research. For instance it predicts that news will be immediately incorporated in asset prices. My research suggests that that is usually the case. The anti-EMH position does not offer me any useful investment advice, nor does it help policymakers. It is literally useless, even if true. I prefer a useful theory that is false, to a useless one that is true.

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