What If Markets Aren't Free? Can They Still be Efficient?

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I recently read a great quote [if anyone knows who said it, I would love to give credit]:

The market is free, like sharks are fish.

Much of the investment advice given is based on the idea of free and efficient markets. But what if the markets are not really free? Can they still be efficient?

In other words:

Do markets have to be free to be efficient?

If markets are not free [I don't know any real person that believes they are right now] and therefore not efficient, should we be rethinking models that are built on those two assumptions?

Due to massive government intervention and outright fraud [some would argue that those are the same thing] there is no question we have something other then free markets. Every day there is some new allegation of insider trading, Goldman Sachs taking over the government, or a massive hedge fund stealing money.

I know the old saying that the last four words of any great investor are “this time it’s different,” but don’t you wonder what the impact of massive government intervention, fraud, globalism, and terrorism will have on the traditional buy and hold approach to investing?

I was a monk in the monastery of buy and hold investing, where you believe that the best you can do is buy a broad-based index and hold on through good times and bad. I always thought of it as an investment in the concept of free market capitalism. So asking these questions feels like I am changing religions, but it is almost impossible not to at least consider it. At this point, I have a duty to my clients to ask these questions.

So if traditional buy and hold investing is a bet on the concept of free market capitalism, what if the current version is not quite as free as the model assumed it would be?

In the past I have decided to have faith that we will work this one out, that somehow good people will make good decisions, and it will all work out. Is that what you have to have…faith?

If faith in the system is required, most real people seem to be losing faith…

I know that these recent posts have been short on solutions and long on questions. There is a reason for that: I use this blog as a forum to ask questions and generate discussion. I’ve had some great conversations here, on Twitter, and via email with many of you. I know that you are thinking about these issues as well, and it helps all of us to talk about it.

In terms of solutions, I have one that works for me and my clients, but arriving at it was a personal journey as are so many things. One thing I know for sure is that the journey is not over. Any really good advisor should never stop studying the landscape because it changes. So for now this is a place to discuss the landscape and not a place for defending maps that might be outdated.

Please let me know what is on your mind. As always, if you feel your question would be better handled in private, feel free to email me.

By Carl on 10.22.09 > Link

Tagged as: efficient markets, free markets

RobBennett

Holy moly! I feel like you must be reading my diary, Carl.

No, the market is not free. And, yes, assuming that it is gets us all into a great deal of trouble.

One place where we part company a bit is with your suggestion that markets are not free only because of "massive government intervention and outright fraud." I see it as being far more basic and simple than that. Markets are never entirely free because markets are comprised of humans and humans are never entirely free. We have a tendency to kid ourselves, okay? And we do harm to ourselves when we do.

My belief is that markets have an inclination to be free. Markets want to be efficient. But this freedom and this efficiency does not happen automatically. The humans have to work at it to make it happen. The popularity of Passive Investing has ruined everything. When people come to believe that the markets are automatically free and efficient, they stop doing what they must do to make them free and efficient in the real world. The more that people come to believe that markets are efficient, the less efficient markets are.

I believe that we need a national debate on these questions. The debate needs to involve not just hundreds of people. It needs to involve millions of people. John Bogle needs to be part of it. Warren Buffett needs to be part of it. The entire Personal Finance Blogosphere needs to be part of it. Our political leaders (both parties) need to be part of it. The big investment forums need to be part of it. We need to wipe out the assumptions that have crippled our thinking for the past three decades and just start fresh trying to figure out what really works in the real world.

We are today living through the worst time in history for middle-class investors to have money in the stock market. Most of today's investors are in all likelihood going to suffer a wipe-out. But that's only one side of the story. The other side of the story is very encouraging news indeed. We have made huge strides in our understanding how stock investing really works. When things get bad enough that those who made mistakes are able to acknowledge them, our knowledge is going to advance in leaps and bounds in a short amount of time. I believe that we are standing on the threshold of the Golden Age of Middle-Class Investing.

The tricky part is surviving the transition from the discredited model to the one that we need to build together to replace it.

Rob

Dylan

I'm a fan of analogies, but I don't quite get the shark thing.

Most people do not view free markets and efficient markets as absolute concepts. You say, "there is no question we have something other then free markets." Okay, but are the markets the complete opposite of "free?" If not, where along that spectrum are they? Are they closer to "free" than "not-free" What about efficiency?

You characterize traditional buy and hold investing as a bet on the concept of free market capitalism, but isn't any market investment a bet on the concept of free market capitalism, whether you buy and hold or buy and sell?

The real question to me is not whether things have changed, or are different, or if there is a new "normal." It's what can I do about any of it?

Beyond all the theories and hypotheses, there is absolute zero-sum math in markets, which becomes negative-sum when money changes hands. Buy and hold indexing is not a bet on efficiency or free markets. It's simply a bet that the aggregate market loss will be greater than aggregate market gain, even if this time actually is different and even if markets are not efficient.

Rob Wood

Part of the motivation for the assumption that markets are "free" is a motivation for consistency: the fact is that consistent systems are easy to work with from a standpoint of generating predictions, and sorting through sets of axioms.

So what I'm saying is that the assumption that the market is "free" in some fashion is an artifact of the approaches taken to economic thinking prior to the advent of paraconsistent mathematics (game theory, Godel, etc). People assumed a free market, and hence one that was efficient, because theorists valued elegance and consistency in their models. Such models are much easier to use than non-elegance and non-consistent models, at least until recently.

I believe there's been some prior discussion about how economics is not a natural science, where such things are elegance and consistency are valuable, but a social science.

The thing about the social sciences is that their areas of study are self-referential, or recursive after a fashion. Using wholly consistent theories to model the behaviour of both elements and the whole will yield some useful results, but only in the short term, and only for the small parts of the system that are consistent. So we get the usual caveats about how real people (as opposed to theorists) understand that the market is not actually free, and not actually efficient, despite the utility of market models predicated on freedom and efficiency.

However, if you employ a model that uses para-consistent logics, talking about whether markets are free or efficient doesn't really make sense any more. But that's not really a problem, because instead of talking about whether markets are free anymore with the caveat that we all know they aren't really, we can talk about the flexibility of market strategies. Likewise, instead of talking about whether markets are efficient, we can talk about the relative efficiencies of various market strategies. So what is a market strategy in all this? It's any market system that any group of politically and economically involved agents might settle on.

Basically my point is that how you plan to talk about a market affects the kind of conclusions you can draw from such talk. Chances are, if you need all sorts of ad hoc caveats (talking about real this and real that) to make a theory relevant to the world, then it's a bad way of talking about the world.

Asking this sort of question is like asking:

So what if God is all-powerful? Can He still create a rock so heavy He cannot lift it?

We could laud this as a mystery of faith, or we could actually do the leg-work and back-track to find out where we went wrong to start asking such irrelevant question.

tucsonbob1938

I am most worried about inflation. We are concerned about having a good return, but is this the most important if the returns are going to be wiped out by increasing (run away?) inflation. Jonathan Hoenig points this out with an illustration from Zimbabwe, Africa in an article that was published in the Wall Street Journal on October 15, 2009:
From May through October of 2008, Zimbabwean stocks skyrocketed, shooting from 72,000 to almost 400,000 by early November as measured by the S&P/International Finance Zimbabwe Index. For intrepid investors with a world bent, it would appear to be an attractive return of roughly 5,300%.

The only problem is that, while investors had indeed earned more Zimbabwe dollars, the value of those dollars over the same period had nearly evaporated amid the country's hyperinflation, meaning the "return" was actually a catastrophic loss. One Zimbabwe dollar in May of 2008 had lost 99.99% of its purchasing power by November of that same year. Investors made thousands of percent in stocks and were still wiped out.

What if Markets Aren’t Free?

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