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Are Profits Purely Random?

Mises Daily: Tuesday, July 24, 2007 by

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An old economist joke goes like this. A person is walking along and says to an economist, look, there is a $20 bill on the sidewalk. The economist disputes it without looking, on grounds that if it were there, someone else would have already picked it up.
 

It's funny but it is also not far from describing a widely held view that financial asset markets always fully reflect all available and relevant information, and that adjustment to new information is virtually instantaneous. This view conveniently overlooks several factors inherent in the market economy: uncertainty, error, and varied forecasting abilities among market participants.
 

The view that profits are random is also known as the Efficient Market Hypothesis (EMH), and is closely linked with the Rational Expectations Hypothesis (REH). The REH postulates that market participants are at least as good at price forecasting as is any model that a financial market scholar can come up with, given the available information. The view that everyone is as good a forecaster as any model implies that their forecasts do not display systematic biases. In other words, forecasts are right on average.

According to the EMH, by using available information, all market participants arrive at "rational expectations" forecasts of future security returns, and these forecasts become fully reflected in the prices that are observed in financial markets. Changes in asset prices will occur on account of news, which cannot be predicted in any systematic manner. In other words, asset prices respond only to the unexpected part of any news, since the expected part of the news is already embedded in prices. Thus, if the central bank raises interest rates by 0.5%, and if this action was anticipated by market participants, the effect of this anticipation will be manifested in asset prices prior to the central bank raising interest rates.

Therefore, when the central bank raises the interest rate by 0.5%, this increase will have no effect on asset prices. If, however, the central bank raises interest rates by 1%, rather than the 0.5% expected by market participants, the prices of financial assets will react to this increase.

The efficiency of the market means that the individual investor cannot outwit the market by trading on the basis of the available information. The implication of the EMH is destructive for fundamental analysis, for this means that analysis of past data is of little help since whatever information the analysis will reveal is already contained in asset prices.

The proponents of the EMH claim that the main message of their framework is that excessive profits cannot be secured out of public information. They maintain that any successful method of making profits must ultimately be self-defeating. EMH proponents even maintain that a dart-throwing chimpanzee can be a good substitute for entrepreneurial activity. One of the pioneers of the EMH who has popularized this framework is Burton G. Malkiel.

The theory holds that the market appears to adjust so quickly to information about individual stocks and the economy as a whole that no technique of selecting a portfolio — neither technical nor fundamental analysis — can consistently outperform a strategy of simply buying and holding a diversified group of securities.[1]

Consequently, Malkiel argues that,

A blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully [chosen] by the expert.[2]

In other words what this approach suggests is passivity and resignation from an active search for opportunities.

Now, it is true that profits as such can never be a sustainable phenomenon. However, the reasons for this are not those presented by the EMH.

The essence of profit

Profit emerges once an entrepreneur discovers that the prices of certain factors are undervalued relative to the potential value of the products that these factors, once employed, could produce. By recognizing the discrepancy and doing something about it, an entrepreneur removes the discrepancy, i.e., eliminates the potential for a further profit. According to Murray N. Rothbard,

Every entrepreneur, therefore, invests in a process because he expects to make a profit, i.e., because he believes that the market has underpriced and undercapitalized the factors in relation to their future rents.[3]

The recognition of the existence of potential profits means that an entrepreneur had particular knowledge that other people didn't have. Having this unique knowledge means that profits are not the outcome of random events, as the EMH suggests. For an entrepreneur to make profits, he must engage in planning and anticipate consumer preferences. Consequently, those entrepreneurs who excel in their forecasting of consumers' future preferences will make profits.

Planning and research never guarantee that profit will be secured. Various unforeseen events can upset entrepreneurial forecasts. Errors, which lead to losses in the market economy, are an essential part of the navigational tools that direct the process of allocation of resources in an uncertain environment in line with what consumers' dictate.

Uncertainty is part of the human environment, and it forces individuals to adopt active positions, rather than resign to passivity, as implied by the EMH. The EMH framework views the act of investment as no different from casino gambling. In the words of Ludwig von Mises, however,

A popular fallacy considers entrepreneurial profit a reward for risk taking. It looks upon the entrepreneur as a gambler who invests in a lottery after having weighed the favorable chances of winning a prize against the unfavorable chances of losing his stake. This opinion manifests itself most clearly in the description of stock exchange transactions as a sort of gambling.

Mises then suggests,

Every word in this reasoning is false. The owner of capital does not choose between more risky, less risky, and safe investments. He is forced, by the very operation of the market economy, to invest his funds in such a way as to supply the most urgent needs of the consumers to the best possible extent.

Mises then adds,

A capitalist never chooses that investment in which, according to his understanding of the future, the danger of losing his input is smallest. He chooses that investment in which he expects to make the highest possible profits.[4]

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"Planning and research never guarantee that profit will be secured."

The EMH framework presents the stock market as a gambling place, which is detached from the real world. However, as Mises suggests,

The success or failure of the investment in preferred stock, bonds, debentures, mortgages, and other loans depends ultimately also on the same factors that determine success or failure of the venture capital invested. There is no such thing as independence of the vicissitudes of the market.[5]

Further to this,

Stock speculation cannot undo past action and cannot change anything with regard to the limited convertibility of capital goods already in existence. What it can do is to prevent additional investment in branches and enterprises in which, according to the opinion of the speculators, it would be misplaced. It points the specific way for a tendency prevailing in the market economy, to expand profitable production ventures and to restrict the unprofitable. In this sense the stock exchange becomes simply the focal point of the market economy, the ultimate device to make the anticipated demand of the consumers supreme in the conduct of business.[6]


Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of Man Financial, Australia. Send him mail and see his outstanding Mises.org Daily Articles Archive. Comment on the blog.

Notes

[1] Burton G. Malkiel, A Random Walk Down Wall Street (New York: WW Norton, 1985), p. 194.

[2] Ibid.

[3] Murray N. Rothbard, Man, Economy, and State (Los Angeles: Nash), vol. 2, p.466.

[4] Mises, Human Action, pp. 809–10.

[5] Ibid., p. 810.

[6] bid., pp. 517–18.