I have an alternative formulation of the efficient market hypothesis – prices accurately reflect the average opinion of everybody’s money.

Let me explain. Let’s go back in time and discuss Moneyball, the awesome book by Michael Lewis about Billy Beane and his Oakland A’s. Key takeaway – on-base percentage is a good predictor of positive outcomes, Billy Beane figured that out and further realized nobody else had, arbitrage opportunity, the A’s are a good baseball team for a while even though they have no money. Tada – market goes from inefficient to efficient.

Here’s what Lars Christensen had to say about that last year:

Isn’t it beautiful? The market is not efficient to beginning with, but a speculator comes in and via the price system ensures that the market becomes efficient. This is EMH applied to the baseball market. Hence, if a market like the baseball market, which surely is about a lot more than making money can be described just remotely as efficient why should we not think that the financial markets are efficient? In the financial markets there is not one Billy Beane, but millions of Billy Beanes.

Every bank, every hedgefund and every pension fund in the world employ Billy Beane-types – I am one of them myself – to try to find mis-pricing in the financial markets. We (all the Billy Beanes in the financial markets) are using all kind of different methods – some of them very colourful like technical analysis – but the aggregated result is that the markets are becoming more efficient.

Like Billy Bean the speculators in the financial markets are constantly scanning the markets for mis-priced assets and they are constantly looking for new methods to forecast the market prices. So why should the financial markets be less efficient than the baseball market? I think Scott is right – EMH is a pretty good description of the financial markets or rather I haven’t seen any other general theory that works better across asset classes.

What is strange about this is that I read it and I think "if the EMH is true, then Lars shouldn’t have a job and neither should any of his co-speculators." To square the circle, you have to believe that markets are, in a sense, always inefficient (though always becoming more efficient).

Here’s my model – there is a market with n actors trading various assets. Each actor has a stochastic probability of individually uncovering some new information or knowledge that leads them to buy or sell something because of belief that the market price is in some sense "wrong" (this is different from trading on simultaneous collective discoveries, like central bank statements or GDP/unemployment reports). So when each actor makes such a discovery, the price becomes more efficient.

This sounds like the market Lars describes. But for it to work, there always has to be more discoverable information or knowledge. Which is fine.

But the Moneyball scenario is way, way weirder. Bill James was writing in the 1980s. Billy Beane became GM of the A’s in 1997 and they started really performing well in 2000. And it still took years for even OBP to be properly-valued in baseball markets. Baseball is a giant industry, probably valued properly in the billions of dollars. How did they let such extremely useful information linger so long before one actor acted on it? And how did it take so long for the arbitrage opportunities to dissolve?

Clearly baseball, going by the model above, has a small n – there are relatively few actors (32 teams) so the odds in any given year of any one team of adopting a new innovation are relatively slim. But under the EMH such new information and knowledge should be extremely contagious. Yet Beane told Lewis he didn’t even care if Lewis wrote a book about how Beane was arbitraging a very expensive and profitable market because he didn’t even think any of the other market actors would read it.

Maybe baseball is weird. But maybe it’s not.

Prices accurately reflect the average opinion of everybody’s money.

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