Chapter 2: FAQs 85
excess returns. This is commonly seen when new con-
tracts, exotic derivatives, are first created leading to
a short period of excess profit before the knowledge
diffuses and profit margins shrink. The same is true of
previously neglected sources of convexity and there-
fore value. A profitable strategy can exist for a while
but perhaps others find out about it, or because of the
exploitation of the profit opportunity, either way that
efficiency disappears.
The Grossman–Stiglitz paradox says that if a market
were efficient, reflecting all available information, then
there would be no incentive to acquire the information
on which prices are based. Essentially the job has been
done for everyone. This is seen when one calibrates
a model to market prices of derivatives, without ever
studying the statistics of the underlying process.
The validity of the EMH, whichever form, is of great
importance because it determines whether anyone can
outperform the market, or whether successful investing
is all about luck. EMH does not require investors to
behave rationally, only that in response to news or data
there will be a sufficiently large random reaction that
an excess profit cannot be made. Market bubbles, for
example, do not invalidate EMH provided they cannot
be exploited.
There have been many studies of the EMH, and the
validity of its different forms. Many early studies con-
cluded in favour of the weak form. Bond markets and
large-capitalization stocks are thought to be highly effi-
cient, smaller stocks less so. Because of different quality
of information among investors and because of an emo-
tional component, real estate is thought of as being
quite inefficient.