Subsuming the Efficient Market Hypothesis

by Keith C. Goddard, CFA, 3/1/11

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In a recent article in Advisor Perspectives, Beyond the Efficient Market Hypothesis, Michael Edesess highlighted important gaps in the efficient markets model (EMH) that limit its practical applications.  In so doing, Edesess encouraged a search for a new theory of markets that builds upon EMH by rendering it as a special case within a broader, more general theory. In essence, Edesess seeks scientific progress… a new theory of markets to subsume EMH the way Einstein’s relativity theory subsumed Newtonian physics.

I present Rational Belief Equilibrium (RBE) as such a theory.

Readers inspired by Edesses’ call to action should investigate RBE, which has been developed at Stanford University by Dr. Mordecai Kurz over the past 16 years.  Kurz’ groundbreaking work is under-appreciated outside academic circles, but it represents a “subsuming” theory for EMH that deserves greater attention from investors.

RBE holds a key advantage over EMH, in that the assumptions needed to “make the math work” pass the smell test of common sense.  For example, one of the key variables in the RBE model is the notion that rational investors make mistakes.  Unlike EMH, which assumes investors are rational robots that know the “true” probability distribution of everything, RBE acknowledges there is no such thing as a “true” probability distribution because the mean, variance and covariance of everything is always changing.  Asset relationships that prevailed before the Great Depression, World War II, the advent of the Internet, or 9/11, were no longer the same in the aftermath of those events

In addition to those major structural changes in the world order, smaller shifts occur all the time that disrupt the behavior of asset prices.  For instance, the correlation between stocks and gold is sometimes positive and sometimes negative.  Knowing the long-term average correlation between stocks and gold is not particularly helpful if the relationship cannot be counted on to remain stable through time.

By acknowledging there is no “true” measure of mean, variance and covariance for anything, RBE strives to model the world the way it really is.  RBE addresses practical uncertainty by asserting that any opinion that cannot be proven false by historical facts should be considered rational.  In this way, two investors can hold opposite opinions about an issue (a buyer and a seller, for example), yet both sides can be rational as long as the historical record does not refute either viewpoint.  Since opposite opinions about the future can never both be proven right, RBE concludes that rational people make mistakes all the time.  The relevance for investors is that these mistakes reflect themselves in asset prices.

Consider the recent boom-bust cycle in the U.S. housing market.  Several thoughtful people correctly anticipated the bust in housing prices.  We consider them the “smart” people today because they were proven right.  But does that imply the remaining 98% of us are imbeciles, including the best and brightest at our leading investment banks, the leadership at the Federal Reserve and the Treasury Department, and the Ph.D.s that populate the major ratings agencies?