# Does the Presence of Technological Innovation Weaken the Efficient Market Hypothesis? NO! Author: Pal Sinha, Barnali Author URL: https://financedigest.com/author/pal-sinha-barnali Published: 2020-10-15 Category: TECHNOLOGY Category URL: https://financedigest.com/category/technology Meta Title: Why Financial Markets Are Efficient - The Truth Revealed! Meta Description: Discover why speculating in the financial markets for supernormal profits is not feasible, even in the age of advanced technology and machine learning. Market URL: https://financedigest.com/does-the-presence-of-technological-innovation-weaken-the-efficient-market-hypothesis-nohtml ![undefined](https://prod.superblogcdn.com/site_cuid_cm5qst7v3003gwirgwqtxn8i8/images/untitled-design-2020-10-15t124131-1736838800762-compressed.jpg) _By **Barry Weinstein,** Founder and CEO of VolatilityFX_ _Why even in the information age, you cannot make above risk-adjusted returns speculating in the financial markets._ Financial markets are efficient without exception.  There is no way for a speculator to generate supernormal profits without undertaking supernormal risk. Even at the highest levels of finance, traders endowed with decades of experience, [millions of dollars of technological](https://www.financedigest.com/nano-one-awarded-10-million-from-sustainable-development-technology-canada.html "Nano One Awarded million from Sustainable Development Technology Canada") infrastructure, and supporting teams of quants and developers cannot generate above risk adjusted returns, and oftentimes underperform passively managed tracker funds. Michael C. Jensen showed the relative disadvantage to day [trading because of the market’s apparent randomness but with the fixed existence of transaction costs](https://www.financedigest.com/fortum-says-rising-costs-of-nordic-power-trading-are-worrying.html "Fortum says rising costs of Nordic power trading are “worrying”"). Numerous studies have been conducted on active fund management vs. passive fund management and showed that actively managed funds tend to underperform indices by roughly the accrued transaction costs incurred during the period (Jensen, 1968).  Even so, in the information age where futuristic methods such as machine learning, optimization, and [artificial intelligence](https://www.financedigest.com/types-of-artificial-intelligence.html "artificial intelligence") are widespread and available, can a new wave of “high tech traders” finally beat the market? The answer is an emphatic NO! **Market Efficiency. What does it mean?** The Efficient [Market Hypothesis was formalized by **Eugene Fama** in a literature review of empirical work on the subject of portfolio management](https://www.financedigest.com/tinnitus-management-market-to-top-us-3-2-bn-driven-by-growing-burden-of-hearing-disorders-fmi.html "Tinnitus Management Market to Top US$ 3.2 Bn Driven by Growing Burden of Hearing Disorders: FMI") in 1970. The conceptual [innovation](https://www.financedigest.com/the-breakfast-cereals-market-to-sail-through-innovation-based-turbulence.html "The Breakfast Cereals Market To Sail Through Innovation-Based Turbulence") of the Efficient Market Hypothesis surmises that markets have no memory of past events and tend to move in brownian motion. Brownian motion can be interpreted as a “drunkard’s walk”, where the direction of movement of an asset price can be described with the predictability of a coin flip.  The asset will [move randomly up and down in increments over a specific time](https://www.financedigest.com/move-over-tina-its-time-for-tara.html "Move over TINA, it’s time for TARA") frame. The result looks like unpredictable wandering without large gaps in distance between steps. **Fisher Black** offered a second definition of an efficient [market at the 1985 annual meeting with the American Finance Association when he asserted, “We might define an efficient market as one in which price is within a factor of two times the value; i.e., the price is more than half the value](https://www.financedigest.com/analgesics-market-value-surpasses-us-77-3-bn-as-demand-for-nsaids-rise-at-4-1-fmi.html "Analgesics Market Value Surpasses US$ 77.3 Bn as Demand for NSAID’s Rise at 4.1%: FMI") and less than twice of value. By this definition, I think almost all [markets](https://www.financedigest.com/automotive-timing-chain-and-belt-market-to-be-valued-at-us-10-20-bn-by-2027-comprehensive-research-report-by-fmi.html "Automotive Timing Chain and Belt Market to be valued at US$ 10.20 Bn by 2027 – Comprehensive Research Report by FMI") are efficient almost all of the time.” Black adds “‘almost all’ means at least 90 percent.” Princeton Economist, **Burton Malkiel** offered a third definition. The author of “A Random Walk Down [Wall Street” defines the concept of an efficient market](https://www.financedigest.com/wall-street-bounces-oil-slides-as-markets-mull-murky-economic-picture.html "Wall Street bounces, oil slides as markets mull murky economic picture") as, “a market that does not allow investors to earn above-average returns without accepting above-average risks” (Malkiel, 2003). There are clear problems with applying the concept of a drunkard’s walk, or series of coin flips to financial [market](https://www.financedigest.com/a-holistic-approach-to-esg-is-the-best-chance-of-success-in-a-competitive-private-equity-investment-market.html "A holistic approach to ESG is the best chance of success in a competitive private equity investment market") s, as there are periods, such as the US equities market in the 1990’s dot-com boom where the equities market made stable positive gains for years on end and nearly without disruption. Between 1995 and its peak in March 2000, the Nasdaq Composite [stock market](https://www.financedigest.com/bitcoin-falls-to-22-month-low-as-stock-markets-tumble.html "Bitcoin falls to 22-month low as stock markets tumble") index rose 400%, only to fall 78% from its peak by October 2002: completely erasing the boom. Eugene Fama’s description of efficient markets does not sufficiently describe the disparate [stable](https://www.financedigest.com/shelf-stable-soup-market-2022-outlook-current-and-future-industry-landscape-analysis-2028.html "Shelf-stable Soup Market 2022 Outlook, Current and Future Industry Landscape Analysis 2028") behaviors of independent markets. Lo and MacKinla used [statistical](https://www.financedigest.com/outside-door-handle-market-analysis-trends-top-manufacturers-share-growth-statistics-opportunities-and-forecast-to-2027.html "Outside Door Handle Market Analysis, Trends, Top Manufacturers, Share, Growth, Statistics, Opportunities and Forecast to 2027") techniques to prove that the continuous successive upward and downward movements known as “trends” were too many and occurred too often to have been a result of brownian sequences. (Lo and MacKinla, 1999)  Similarly, Lo, Mamaysky and Wang demonstrated that certain patterns in technical analysis did have predictive ability in relation to [future securities](https://www.financedigest.com/contactless-payments-the-way-of-the-future-or-security-scare.html "Contactless Payments – The Way of the Future or Security Scare?") prices. (Lo, Mamaysky, Wang, 2000). Lev and Thiagarajan show that fundamental [analysis can forecast future earnings reports and then predict](https://www.financedigest.com/covid-19-impact-on-attitude-and-heading-reference-systems-market-volume-analysis-future-prediction-industry-overview-and-forecast-2028.html "Covid-19 Impact On Attitude and Heading Reference Systems Market | Volume, Analysis, Future Prediction, Industry Overview And Forecast 2028") future asset prices with a fair amount of accuracy (Lev and Thiagarajan, 1993). Black’s definition of efficient markets inherently relies on the concept of a fundamental, or objectively fair price of an asset, which is to be determined or estimated by teams of accountants, and analysts who form their own scientific estimates of value (Black, seen in Mehrling, 2005). Black’s definition implies that the fundamental value of a security can be used (in rare circumstances) to exploit mis-pricings in the [market which have valuations](https://www.financedigest.com/u-s-automotive-and-aircraft-interior-genuine-leather-aftermarket-is-expected-to-push-sales-at-3-6-cagr-with-the-market-valuation-reaching-us-11-1-bn-in-2031.html "U.S. Automotive and Aircraft Interior Genuine Leather Aftermarket is expected to push sales at 3.6% CAGR, with the market valuation reaching US$ 11.1 Bn in 2031") deemed unreasonable by teams of analysts.  Black’s definition does not take into [account that predicting future](https://www.financedigest.com/fingerprint-scanners-to-remain-top-selling-accounting-for-over-one-third-of-access-control-demand-in-2021-future-market-insights.html "Fingerprint Scanners to Remain Top-selling, Accounting for Over One-third of Access Control Demand in 2021: Future Market Insights") asset prices with a high probability does not necessary in result in the ability to generate above risk-adjusted profits. Most of the US equity traders [participating in the dot-com bubble had a fair idea that the market](https://www.financedigest.com/powder-dispenser-market-market-2019-2029-where-should-participant-focus-to-gain-maximum-roi.html "Powder Dispenser Market Market (2019 – 2029) | Where Should Participant Focus To Gain Maximum ROI ") would be positive the next day. Most of these traders, without any software, or market acumen, were able to more or less accurately [predict the diffusion of the US equities market for 5 years](https://www.financedigest.com/predicting-wind-storms-35-years-on-from-the-great-storm.html "Predicting Wind Storms 35 years on from the Great Storm "). Even so, one statistical outlier, such as the dot-com bust, can reverse the gains of a successful multi-year strategy. The “most statistically accurate” traders suffer the worst losses while the “most statistically inaccurate” traders are made an overnight success. From a fundamental value perspective, there is also the problem of a theoretical [equity whose valuation is five times it “fair” price](https://www.financedigest.com/global-equities-waver-on-inflation-view-as-falling-oil-supplies-lift-prices.html "Global equities waver on inflation view as falling oil supplies lift prices"). When the [market valuation](https://www.financedigest.com/emission-control-catalyst-market-is-projected-to-rise-at-above-10-cagr-surpassing-the-market-valuation-of-us-20-06-bn-during-the-forecast-period-2021-2031.html "Emission Control Catalyst Market is projected to rise at above 10% CAGR, surpassing the market valuation of US$ 20.06 Bn during the forecast period 2021-2031") was four times its fair price, before reaching its peak, if a trader had sold short due to model recommendations, the trader would have lost money despite being “right.” The exuberant trend follower, who exclaims “it’s the hot stock to own right now!” would conceivably make money despite being “wrong.” It is the position of this [article that Malkiel’s definition of an efficient market](https://www.financedigest.com/paid-guest-posts-the-dos-and-donts-of-article-marketing-part-ii.html "Paid Guest Posts – The Dos and Don’ts of Article Marketing Part II") holds the most weight. The risk [adjusted return](https://www.financedigest.com/uber-could-post-first-adjusted-profit-this-quarter-as-ride-demand-returns.html "Uber could post first adjusted profit this quarter as ride demand returns") viewpoint does not imply that assets even trade near their fair value, as Black implies. Malkiel also does not suggest that markets behave randomly as Fama implies. USD/SAR and USD/HKD, for example, are clearly not random given their respective currency pegs, and yet they are some of the most difficult [markets to extract](https://www.financedigest.com/functional-extracts-market-potential-growth-share-demand-and-analysis-of-key-players-forecasts-to-2029.html "Functional Extracts Market Potential Growth, Share, Demand and Analysis of Key Players – Forecasts to 2029") returns from. It would be an expensive and academic exercise to start trading SAR and HKD based on their respective “fair values” as long as their [pegs](https://www.financedigest.com/benign-positional-vertigo-treatment-market-is-pegged-to-witness-sound-growth-in-terms-of-value.html "Benign Positional Vertigo Treatment Market Is Pegged To Witness Sound Growth In Terms Of Value") are enforced. **Intelligent Design, or Natural Selection: Who decides the price?** Friedman asserts that market selection pressure would eventually result in behavior consistent with the maximization of general equilibrium, and those who behave irrationally will be [driven out of the market](https://www.financedigest.com/demand-for-automotive-radiator-market-driven-by-shifting-consumer-perceptions-and-growing-awareness.html "Demand for Automotive Radiator Market Driven by Shifting Consumer Perceptions and Growing Awareness") by those who behave as if they are rational (Blume and Easley, 2006). This proposed phenomenon is known as the Market Selection Hypothesis (Alchian, 1950). Of course, Friedman assumes that rationality alone is sufficient make above [risk adjusted return in the markets](https://www.financedigest.com/bank-of-england-says-it-will-unwind-bond-market-intervention-once-risks-have-subsided.html "Bank of England says it will unwind bond market intervention once risks have subsided"). DeLong, Shleifer, Summers, and Waldmann, formally analyzed profits of noise traders and rational traders and found that the noise traders had a higher [expected value](https://www.financedigest.com/valve-seat-inserts-market-was-estimate-to-be-valued-at-us-5-bn-in-2019-and-expected-to-grow-at-a-cagr-of-4-during-the-forecast-period-of-2019-2029.html "Valve Seat Inserts Market was estimate to be valued at ~US$ 5 Bn in 2019, and expected to grow at a CAGR of ~4% during the forecast period of 2019-2029") than the rational traders. They argued that irrationally overconfident noise traders have the ability to be the primary influencers of asset prices in certain asset classes (DeLong, Shleifer, Summers, and Waldmann, 1991). The market’s ability to take low quality information from thousands of noise traders and synthesize a [market clearing](https://www.financedigest.com/sales-growth-of-automotive-clear-vision-systems-market-is-driven-by-production-of-new-vehicle.html "Sales Growth Of Automotive Clear Vision Systems Market Is Driven By Production Of New Vehicle") rate that maximizes the general equilibrium given environmental constraints is nothing short of a miracle. [Technological innovation](https://www.financedigest.com/transforming-the-retail-banking-ecosystem-its-all-about-technological-innovation.html "TRANSFORMING THE RETAIL BANKING ECOSYSTEM: IT’S ALL ABOUT TECHNOLOGICAL INNOVATION") has drastically reduced operating costs associated with market participation, but there are limits to what science can achieve with regard to speculation and asset pricing. There is no [network of computers](https://www.financedigest.com/hackers-hit-italian-oil-company-enis-computer-networks.html "Hackers hit Italian oil company Eni’s computer networks"), however powerful, that can calculate a market clearing rate with greater efficiency than performed by the price mechanism. The Efficient Market Hypothesis, even given [advanced technological](https://www.financedigest.com/cardiac-valvulotome-market-growth-latest-trends-top-players-competition-technological-advancements-outlook-and-forecast-2028.html "Cardiac Valvulotome Market Growth, Latest Trends, Top Players, Competition, Technological Advancements, Outlook and Forecast 2028") innovation, stands. --- This blog is powered by Superblog. Visit https://superblog.ai to know more. ---