Economic Jujitsu: the Efficient Market Model
The efficient market model states all security prices today reflect all available information and only new information is going to change the price.
EMANUEL DERMAN is Head of Risk at Prisma Capital Partners and a professor at Columbia University, where he directs their program in financial engineering. He is the author of My Life As A Quant, one of Business Week's top ten books of the year, in which he introduced the quant world to a wide audience.
He was born in South Africa but has lived most of his professional life in Manhattan in New York City, where he has made contributions to several fields. He started out as a theoretical physicist, doing research on unified theories of elementary particle interactions. At AT&T Bell Laboratories in the 1980s he developed programming languages for business modeling. From 1985 to 2002 he worked on Wall Street, running quantitative strategies research groups in fixed income, equities and risk management, and was appointed a managing director at Goldman Sachs & Co. in 1997. The financial models he developed there, the Black-Derman-Toy interest rate model and the Derman-Kani local volatility model, have become widely used industry standards.
In his 1996 article Model Risk Derman pointed out the dangers that inevitably accompany the use of models, a theme he developed in My Life as a Quant. Among his many awards and honors, he was named the SunGard/IAFE Financial Engineer of the Year in 2000. He has a PhD in theoretical physics from Columbia University and is the author of numerous articles in elementary particle physics, computer science, and finance.
People tried for centuries to predict where asset prices would go, whether it was wheat or gold and eventually the stock market. And eventually, sometime around the ‘60s, academics began to realize that you really couldn’t say what was going to happen tomorrow and that you had, most of the time, no better facility than just chance in saying whether a stock price would go up or down tomorrow.
I like to say they turned that weakness into a strength in a sort of Jujitsu sort of way and said, “Okay, I’m going to make that a principle. Nobody can say what’s going to happen tomorrow because markets are efficient." That’s the core of the efficient market model which states all security prices today reflect all available information and only new information is going to change the price. That's a slightly vague statement that’s saying, "you can’t really be smarter than the market because the market has really reflected all of its information in the price today." And that’s the core of the efficient market model.
And I think it is more or less true. People can’t in the sort term say what’s going to happen to prices tomorrow, although there are obviously counter examples. And it’s not an absolute law like Newton’s Law is, it’s just a sort of tendency. And I don’t have a lot of problem with that. I think the bigger mistake that people have made in the efficient market model is saying that stock prices diffuse like smoke. And everybody knows that, strictly speaking, that's not true, but nobody has a really shorthand better way of describing what stock prices do. And so they rely on this simplified mathematics and if you think about smoke diffusing, it moves very slowly and smoothly. A piece of smoke doesn’t suddenly jump from here to there. It makes its way slowly there by diffusion.
And stock prices do that some of the time, but occasionally, if you look through the last crisis or through the ’87 crash or through almost any couple of months on the stock market, individual stocks jump 10 percent or some piece of news comes out and the market drops 18 or 20 percent in an instant. And that’s not diffusion, that’s a crash, that’s a jump, that’s something violent.
In the efficient market model as traditionally interpreted, it doesn’t allow for those kinds of violent sorts of behavior. And really, that violent behavior more or less happens a lot of the time. So that’s one of the big flaws of the model. And I think that people who work with the model know that it’s wrong. It’s not like they’re really stupid and they think its gospel. But at the same time, they don’t have a simple way of doing better.
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