Different Paths to the Same (Disconcerting) Destination?

The Efficient Market Hypothesis (EMH) and the “Black Swan” Hypothesis (BSH) take very different paths to the same destination, as follows:

EMH rejects economically significant financial return predictability based on beliefs that: (1) current prices fully reflect (at least within the limits of search/trading costs) available information; and (2) the nature/arrival time of new information is (by the definition of “new”) unpredictable. Testing of EMH includes proactive analyses of the average investor/trader experience (see, for example “The Cost of Hope?”) and reactive challenges to anomalies as discovered.

BSH approaches the same destination of financial return unpredictability based on the belief that financial market returns have power law, rather than Gaussian/normal, distributions that imply intractable uncertainty (unpredictable extreme events substantially determine distribution statistics). Testing of BSH consists of analyzing large samples of financial asset returns to infer their likely distributions.

Both EMH and BSH challenge at fundamental levels the continuity of relationships between/among financial variables, but the two hypotheses seem independent. Neither obviously requires that the other be true or false, though BSH may contest the EMH assumption that the distribution of investor/trader reactions to new information is normal.

An explicit corollary to both hypotheses is that realized abnormal returns are essentially randomness. Through defective modeling (such as incorrect assumption of normal distributions and inadequate accounting for trading frictions), poor sampling (biased or simply too small) and defective statistical techniques (such as data snooping), investors and traders fool themselves into believing that abnormal returns are attributable to skillful application of predictable relationships.

A perhaps implicit corollary to EMH and BSH is that an imperative for skill-belief derives from needs to feel, and to project to others, a sense of control, self-worth, optimism, personal manifest destiny.

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