Efficient Market Hypothesis

[caveden]

The EMH says that market prices are approximately "correct" and you can't expect large gains.

I never heard this acronym before but this statement is not right.
Market prices help entrepreneurs finding out which activities allocate resources better. Some of these activities may bring you large gains, why not?

[FreeMoney]

Maybe think of it this way. In a free market people who have good information the indicates prices should be different than they are will use it to buy or sell continuously until the price moves, or sell the info to someone who can. If the info is crap/uncertain/misinterpreted/already accounted for then people acting on it will tend to go broke, over time this leaves people who are only using relevant, accurate, unaccounted for information and prices will be the most accurate signal to look at.

Maybe phrase it this way. If you have better info about the value of something than it's current price then you can get rich by sharing it! Since you almost never will have this info, you should rely on the market price.

None of this applies to reality to any great extent because the number of free markets is zero.

Insider trading is illegal!

[ZeroPoint]

The EMH says that market prices are approximately "correct" and you can't expect large gains. Yet many Bitcoiners expect large increases in the price of bitcoins. Is the EMH failing in the Bitcoin market, giving us a true free lunch? Or are Bitcoin investors deluding themselves by not recognizing the likelihood of loss?

Efficient compared to what?  Free markets are certainly more efficient than:
1.  Zero trade - each person attempting to create/supply all his own needs/goods/services
2.  Barter - direct trade with no medium of exchange
3.  Regulated trade - prices set and/or resources allocated by gov't bureau-Rats based on a) severe lack of information, b) incompetence, c) corruption

But despite being more efficient than the alternatives, free market pricing is really only efficient (in the sense meant in the EMH) on the average and in the long run.  In the short term there is often volatility around the mean due to innumerable factors including people's changing wants & values, unforeseen events, etc.

You're not factoring in the risks. If bitcoin fails we lose all our money. Secondly you're not factoring in time preferences, lots of money now is worth more that lots of money later (this is why you get above inflation interest rates on savings).

The value of bitcoins at the moment is:
  (Value of bitcoins when successful) * (Chance that bitcoin will succeed) * (Time preference factor)

Excellent points made here.  The fact that Bitcoiners expect bitcoins' value to rise dramatically doesn't indicate a failure of the EMH.  Bitcoins are likely priced about right for their value today.  Bitcoiners are simply doing what every good entrepreneur / speculator does.  We are making a prediction / educated guess / bet about what will happen in the future, i.e., that as time goes by many others will become more knowledgeable about the nature of money and currency and will come to value bitcoins much more than they do now.  If our prediction is correct, we profit; if not, we lose.  C'est la vie!

[ptd]

But despite being more efficient than the alternatives, free market pricing is really only efficient (in the sense meant in the EMH) on the average and in the long run.  In the short term there is often volatility around the mean due to innumerable factors including people's changing wants & values, unforeseen events, etc.

That's because the value of stuff can be volitile in the short term as well. For an extreme example, if there is a hurricane approaching, the price of food goes up because food becomes more valuable. If you think the value of stuff on the market is mispriced, it is usually because the market knows stuff you don't than the other way around (that's what the EMH says).

[ptd]

Insider trading is illegal!

It's not neccesarily bad though. Any rational trading (irrational traders end up bust very quickly), tends to transmit information to the market. Speculators are useful because they amagamate information and transmit to the market (when they get it wrong they lose money). Even pure price analysis can be useful because if you see patterns that indicate insider trading you amplify the message the traders are sending.

[FreeMoney]

Insider trading is illegal!

It's not neccesarily bad though. Any rational trading (irrational traders end up bust very quickly), tends to transmit information to the market. Speculators are useful because they amagamate information and transmit to the market (when they get it wrong they lose money). Even pure price analysis can be useful because if you see patterns that indicate insider trading you amplify the message the traders are sending.

It isn't bad at all. Incorporating your information into the market price is a service to countless people. It makes planning and allocating resources correctly possible.

I said it to illustrate how the EMH could be true, but would not mean anything about our world because we have never seen a free market. It is explicitly illegal to trade on information that would make prices move to their correct levels!

[ZeroPoint]

But despite being more efficient than the alternatives, free market pricing is really only efficient (in the sense meant in the EMH) on the average and in the long run.  In the short term there is often volatility around the mean due to innumerable factors including people's changing wants & values, unforeseen events, etc.

That's because the value of stuff can be volitile in the short term as well. For an extreme example, if there is a hurricane approaching, the price of food goes up because food becomes more valuable. If you think the value of stuff on the market is mispriced, it is usually because the market knows stuff you don't than the other way around (that's what the EMH says).

Great point, great example.  Thanks ptd.

[ptd]

It is explicitly illegal to trade on information that would make prices move to their correct levels!

If you think about it the government is engaging in large amounts of complicated market manipulation. Most market regulation is actually about stopping the market from effectively transmitting information. This effect can be very subtle, I suspect that the dollar is partly kept up by goverment regulations requiring banks to own "safe" assets. Markets are very ruthless to inefficient beings (like governments).

[ptd]

EMH does not help at all to base meaningful financial decisions upon.

Rule 1 of economics is you cannot make money without doing something useful.

Your market analyses are looking into the market data and finding out what the trends are signal (rising price of a company as it becomes successful, thus less risky) and what is noise (bubbles). When you trade based on these analyses you make amplify the signal, thus making markets efficient.

The EMH is not useful in this regard, because knowing the market is usually right does not tell you when it is wrong (which is the whole basis of speculation to begin).