In financial markets, one observes two different types of relationships between prices and information.
- Type D for Deductive: Consider the available information and then calculate a price. The classical model of how to value things.
- Type I for Inductive: Consider the price, assume it contains informational content, and derive the information from the price.
In theory, financial markets operate mainly with Type D, but I think in practice, markets operate mainly with Type I. In the real world, one observes investors and analysts assiduously building models to explain and thereby justify prevailing prices. Paradox? The more one believes the market is Type D, aka the EMH, the more the market actually behaves as Type I. The more you believe the market is efficient, the more information you assume is embedded in market prices.
Hence, the more information you assume is embedded in market prices, the more you operate as Type I, inductively reasoning from prices. Therefor, the more one believes the rest of the market is Type D, the more likely oneself is Type I. Hence the widespread belief in market efficiency leads to inefficiency, as investors reason from prices vs from a priori information?
Is this a robust explanation of boom and bust cycles within a market in which most investors are trying to be rigorously logical?
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