Red-Blooded Risk: The Secret History of Wall Street

The Price Is Right ... Not!

Another misrepresentation is that efficient markets means the market price is always right. That's absurd. Of course prices aren't always right. If they were, they wouldn't change. Any idiot can see security prices change, and in fact change far more than economic fundamentals do. While the technical definitions get complicated, a simple formulation of the efficient markets hypothesis is that the market price is right on average. That may seem like a small thing, but it's much better than human experts can claim.

Therefore, if the price of oil today is $100 per barrel, that price is not necessarily wise or good, and it certainly doesn't have to be fair. What is true is that it's darn hard to make money consistently either buying at $100 or selling at $100. Where people go astray is to make long chains of reasoning starting from the assumption that $100 is the correct price in some sense. Or, if they're quants, they do the same thing by putting $100 as a model input and generating some complex output as a result. While the $100 is likely to be right on average, the average prediction based on $100 being exactly right will be exactly wrong.

If this distinction seems subtle, consider two examples. The first one is purely mathematical. I have two unbalanced coins; one has a 10 percent chance of flipping heads, and one has a 90 percent chance. I pick one of them at random and offer a security that pays $100 if the next flip of that coin is heads. The market ...