🔎 Overview of EMH

EMH is based on a simple concept:

• Every security has a fair price and the stock markets will find that price “efficiently”

How is the fair price of a stock determined?

• Using Expected Value and Present Discounted Value.

EMH: says that at any given time, the price of a stock in the markets will equal the fair value of the stock based on the available information.

🙋‍♀️ But wait… isn’t the fair value just an estimate?

✔ Yes. It’s an estimate that we tend to agree on to some degree.

What does Rob think of EMH?

• I think everyone needs to respect just how efficient the markets can be.
• My favorite way to think of EMH is to say that “So much information about future prices has already been included in the market price that it is extremely difficult to make money by outsmarting the market [unless you take risk or find some inefficiency in the market].”

Why must markets have some level of efficiency?

• Suppose TSLA = $1100.
• Suppose, through diligent research, you find out that TSLA will be $1150 tomorrow. In this case, you should invest all the money you can get in TSLA. You buy it today for $1100 and sell it tomorrow for $1150.
  • As a result:
    • Price today ↑ $1115 (I bought it today and drove the price up)
    • Price tomorrow ↓ $1135 (I will sell it tomorrow and drive the price down. I’ve sold so much that the price will never actually reach $1150. I’m a “whale” who can move prices like this.)
• Next, someone else does their own research and finds out that the price tomorrow will be $1135. Given that the price today is $1115, they will also buy as much TSLA as they can. As a result
  • Price today ↑ $1125
  • Price tomorrow ↓ $1125.
• Inevitable conclusion: if people can predict the future price, arbitrageurs, like you and the other investor, will step in until Price today = Price tomorrow. As a result, it will be very hard to make money in the stock market. You will have to be able to dig up information that other people can’t find.
• We can summarize this as followed: if something is underpriced relative to its future price, arbitrageurs will buy it and drive the price up. If it is overpriced, relative to its future price, arbitrageurs will sell it and drive its price down.

🙋 The market is fairly efficient because arbitrageurs are always trying to make money. By doing this, they force it more toward the efficient price.

• Note that the arbitrageurs won’t have an incentive to seek out information and trade unless the market is a little inefficient. This is Grossman Stiglitz. We won’t have arbitrageurs making the market more efficient unless the market is a little inefficient.

If we think that some companies are inherently more profitable than others, then people will buy the profitable companies and sell the unprofitable ones. The prices of profitable companies will rise until the companies are not that special any more compared to their stock prices Eventually, everything will be priced, to some degree, fairly.

But wait, your TSLA example is silly. What if you don’t know what the price of TSLA will be exactly? You just have some estimates of what it might be.

• You’re right. That must be taken account of. That’s why Bruce introduces the concept of Expected Value in the slides.

But wait, your TSLA example is still silly. What if you can’t predict what the price of TSLA will be tomorrow, but you can predict what the price of TSLA will be in a year?

• You’re right. That must be taken account of. That’s why Bruce uses PDV in his slides.

But wait, your TSLA example is silly. What if TSLA pays a dividend while you hold it?

• You’re right. That must be taken account of. That’s why Bruce includes dividends in his slides.

🙋‍♀️ Arbitrage is the concept that the ability of investors to take advantages of mispricing would immediately make the opportunity go away, is that what we are saying?

✔ Very close. Arbitrage is taking advantage of a mispricing.
It also turns out that when you take advantage of a mispricing (ie do arbitrage), the opportunity goes away.

If it is very risky to do arbitrage, the opportunity will not go away (ie securities will remain mispriced and markets won’t be efficient.)