The Efficient Market Hypothesis: The 7 Levels of Nate Silver

By The Banker | Audio Posts, How Not To Invest, Investing
14 Feb 2014
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Nate_SilverOne of the most important, but controversial, ideas of investing is the ‘efficient market’ hypothesis.

I say important, because it provides a great starting point for approaching investing and markets humbly, as well as for approaching the Financial Infotainment Industrial Complex with a healthy dose of skepticism.  Most investors would be better off if they understood and believed in the efficient market hypothesis.

I say controversial because extreme – or rigid – versions of the efficient market hypothesis can be either disproven or mocked or shown to be untrue in a variety of ways.

Why is this on my mind?

In the next few days I’ll be posting a podcast interview I did a few months ago with author Lars Kroijer, whose book Investing Demystified builds on the basic idea that very few of us actually have an ‘edge’ in the markets. As a result, we would be better off adopting a simple, low-cost approach to our investments.

Reviewing that podcast interview reminded me of my favorite presentation of the efficient market hypothesis, from Nate Silver’s The Signal and The Noise.

Silver doesn’t accept the discredited rigid definition of the efficient market hypothesis, but rather builds a series of increasingly accurate versions through steps 1 through 7.  I read this portion of the Silver book to Kroijer, so I thought I’d just post the transcript of our interview here, as a preview to the upcoming podcasts:

——————————

Michael:          My favorite version of the efficient-market hypothesis was written by Nate Silver in The Signal and the Noise. Have you read that book?

Lars:                No.

Michael:          Do you know who he is?

Lars:                The New York Times guy? [More recently, ESPN, of course]

Michael:          Yeah and Fivethirtyeight.com where he does political forecasting. He’s an interesting thinker and I really recommend the book. But he has a statement of the efficient-market hypothesis that matches his view of the world, which is a probabilistic view in which you end up saying things much less certainly about the future, but maybe more accurately, because the future itself is uncertain. He has seven levels of the efficient-market hypothesis, which I just want to read to you, because it’s really fun.

Level 1:  “No investor can beat the market.”

Okay, that’s very strong, very simple.

Level 2:  “No investor can beat the stock market over the long run.”

That’s a bit, more qualified.

Level 3:  “No investor can beat the stock market over the long run, relative to his level of risk.”

Okay, that’s more sophisticated.

Level 4:  “No investor can beat the stock market over the long run, relative to his level of risk, and accounting for transaction costs.”

Okay, makes sense.

Level 5:  “No investor can beat the stock market over the long run, relative to his level of risk, and accounting for transaction costs, unless he has inside information.”

Makes sense.  The second-to-last one is:

Level 6:  “Few investors can beat the stock market, over the long run, relative to their level of risk, and accounting for the transaction costs, unless they have inside information.”

Finally, the most complete version of the efficient-market hypothesis, which makes sense to me.

Level 7: “It is hard to tell how many investors beat the stock market, over the long run, because the data is very noisy. But we know that most cannot, relative to their level of risk, since trading produces no net excess return, but entails transaction costs. So unless you have inside information, you’re probably better off investing in an index fund.”

Lars:                I like that.

Michael:          He’s a good writer and he has an awesome way of talking about how do we understand the future in a probabilistic way. It’s a sophisticated way of talking about the different levels of extreme efficient-market hypothesis, versus a more – probably correct – nuanced way.

Lars:                I think unfortunately the way it’s sort of been very roughly done in theory, it’s sort of been discredited.

Michael:          If you go to the extreme version, you can discredit it, I think.

Lars:                So no one will really look at it today. It’s not something widely discussed. One of the reasons being is that not many people are really all that interested in discussing it widely. I like what he’s talking about.

 

Please see related post book review of The Signal and The Noise, by Nate Silver

The Signal and The Noise

Please see related post book review of Investing Demystified, by Lars Kroijer

Investing Demystified

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4 Comments

  1. […] markets work. Moving from mathematics into statistics, I tend to side with Nate silver’s efficient market hypothesis. And if I ever started investing, I think I would take on Nasim Taleb’s 90% very safe, 10% […]

  2. ac says:

    “trading produces no net excess return”

    I’d have liked to have this statement clarified. Does this meant that all companies who trade (eg. physical goods) but have to pay for (eg. logistic) costs, are actually doing worse than those investing in Global ETF that probably includes a bunch of companies not doing so well? Though from perspective of accounting / taxation, of course companies prefer to have no returns, atleast in the that country where the business was made.

    Lets say some central bank announces they have started printing money and we all know how hard that is to stop by now. Is this not the “edge” that retail investor needs? If that is an edge, all you need to figure out is how to enter into the position in a leveraged manner in such a way that you won’t get stopped/margin called on the short until the currency really depreciates. This can be done by loaning from entity not concerned with short term fluctuations.

    What about the exit? Well one idea is to close a % of the current remaining leveraged position every interval or on a condition where there is reason to believe the long term edge is no longer present, such as another central bank announcing they print even more money.

    As far as I can see, there is excess return here – you are transferring the printed money to your pocket. Where did I go wrong?

    • The Banker says:

      To answer the beginning part of your comment: “Trading” in the Nate Silver phrase does not refer to physical goods, but rather, trading securities like stocks, bonds.

      As for your second part: I don’t believe a retail investor can ‘beat the market’ by interpreting Central Bank comments indicating an imminent currency devaluation, for a variety of reasons. 1) Central Bank announcements are not nearly easy enough to interpret 2) Their effects are not linear/causal enough to enact a profitable trading strategy 3) Entering a leveraged position that can’t be stopped out is trickier than you make it seem 4) Exiting the position on some set profitable interval is, again, much harder than it sounds.

      I would not wish this ‘trading strategy’ on anyone.

      But – in the happy circumstance that I’m wrong – you and anyone pursuing this strategy should be happy since I’m helping keep the trade from getting too crowded. 🙂

  3. ac says:

    “To answer the beginning part of your comment”
    What I was trying to say is that I fail to see the difference. Both involve business expense, whether its those physical business costs or the spread/commissions in securities trading.

    Yet for some reason it’s like if there was some difference here. Any kind of trading activity is about working the supply and demand of the traded product and involves some amount of guess work – with physical goods you also have some inventory. With physical goods trading, if you are involved in too few products, hows that different from “all eggs in one basket”. All in all, what is the difference between physical goods and securities trading? A lot of writing in the blog makes it sounds like one produces returns and another doesn’t.

    So on the “trading produces no net excess return”, what do physical trading companies produce that keeps them in business if not excess return on their trading?

    “Entering a leveraged position that can’t be stopped out is trickier than you make it seem”

    If you take some sort of bullet loan (lets say couple years) from people who you personally know, how are you going to get stopped out if your trades last from days to months?

    I haven’t tested this but after I read your post about “delta hedging” in options, it seemed to almost suggest that if you bought a stupendous amount of put options from the market maker, the market maker would have incentive to stop the options going in the money. I haven’t done the math but that sounds like it could be applied in buying stocks with leverage, if you can buy them from non-market makers. Right?

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