Financial Econometrics and Empirical Market Microstructure

Social Markets Hypothesis

This social adoption process suggests an amendment to the Efficient Markets Hypothesis (EMH), which maintains that investors are rational and information is fully reflected in prices. Given that human beings (still) make investment decisions, extended periods of risk myopia and social diffusion of information is more realistic. Crucially, disruptive new insights often enter from the periphery and must first be validated by Early Adopters before diffusing into broader markets in successive waves. This process can take many months. Far from being rational homo economicus, investors are social decision makers, subject to cognitive biases and herd mentality. While markets may approach efficiency in the long run, in the short run a Social Markets Hypothesis is more realistic. Disruptive information is not evenly distributed, and must contend with entrenched cognitive biases, and jump through a successive social adoption hurdles. It might explain why U. S. equity markets peaked October 2007, ignoring obviously escalating systemic risk for so many months. A major implication is that prices only indirectly reflect all available information. Absolute price levels and volatility are lagging indicators, while outliers in price and volatility changes are leading indicators. We will illustrate this theme with several case studies.

As William Gibson recognized: “The future is already here. It’s just not evenly distributed yet” (1999). Or, information about credible potential risks is already here. It just hasn’t been widely adopted yet.[15]