Thursday, 29 November 2007

Beating the Monkey 2

After a day listening to the sad tale of a Teddy Bear called Mohammad and of problems in the Labour Party I return to the problem of market efficiency. Traditionally market efficiency has been expressed in terms of 'information' efficiency - that is data which has the ability to alter beliefs. However, I think the idea that markets price information is wrong - they price knowledge which as Plato observed can be defined as 'justified true belief'. Information is that which informs belief - but it is not the whole of belief. Belief is what we think we know about the world and all of us form our beliefs in a variety of ways and some of those beliefs are justified and true and some are irrational and ideosyncratic. The problem is that we find it almost impossible to identify which is which.

Markets have the ability to seperate knowledge about companies (i.e., the justified true beliefs of those who come to trade securities) from the irrational components of belief by a very simple process. It works through four simple but necessary conditions being met: commitment, independence, lack of frictions, and the law of large numbers. Commitment arises when market participants recognise that in acting on their beliefs they risk loss. Traders must have something to lose. Independence is that for an efficient market to operate traders must be independent of one another in their decision making. Frictionless markets are important in that they allow an equilibrium price to be formed without transactions costs impeding the marginal trade and finally the law of large numbers (LLN).

What LLN does is that it allows beliefs that are not correlated with the underlying reality of the asset supporting a security to be diversified away. Irrational belief is by its nature uncorrelated with underlying reality, like unsystematic risk its influence in a large market is likely to be ideosyncratic and self cancelling. In other words, through the pricing process the pluses and minuses cancel out out to 'noise', leaving the pure gold of rational belief as the driver of price.

The paradox is of course that as individuals we cannot easily judge what is rational and what is irrational in our own beliefs. We find it hard to justify our beliefs never mind test their truthfulness in a way that would satisfy Plato's definition of knowledge. So no individual is likely to be able to outrationalise the market - not even Warren Buffet is free from prejudice and irrational components of belief. His pricing of a security is contaminated by the irrational as it is with the rest of us - but the market overcomes this problem.

There is much more we could say about this interpretation of efficiency but I think that will do for now. I return to News 24 and confront the irrational idea that we as humans need to punish those who wittingly or unwittingly insult an all powerful God or his prophet, who if he exists, has got all eternity to make us suffer for our impudence. But that reminds me Bloggees - is it possible for God to be all powerful? Can he create a stone that is too heavy for him to lift? Think about it.

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