“I guess we’re all behaviorists now”
-Richard Thaler

 

One of the most widely believed theories on Wall Street is the Efficient Market Hypothesis (EMH). Adherents of this charmingly naive thesis believe that markets are an incredibly effective distributor of information. Because of this, say EMH theorists, it is impossible, therefore, to beat the market, because prices already incorporate and reflect all relevant information.

Given the random nature in which market and company information comes to investors, and the assumption that prices react/adjust almost immediately to reflect this information, no one can consistently outperform the market over time.

Or so goes the theory.

The thesis has two problems: 1) Many fund managers and investors HAVE outperformed the market. Theorists have never come up with an adequate response to this reality, claiming instead that chance or mere short term market swings explain the out-performance; and 2) it imbues the market with an almost mystical ability to disseminate information, regardless of the emotions and analytical failures of its human participants.

Now Eugene Fama, the father of the EMH, has surprised much of the academic world. At a conference honoring Professor Fama last month, he presented a paper that made the case that poorly informed investors could theoretically lead the market astray; Stock prices, he noted, could become “somewhat irrational.”

Are you suggesting that people may a times be irrational? Shocking!

What the good professor is finally acknowledging is the inherent fallibility of mortal investors. Human beings are highly imperfect organisms as investors. They are impatient, given to bouts of fear and greed, make analytical errors, suffer from bad data interpretation, overrate their own abilities. And that’s before we get to POS (plain ole stupid).

Thomas Gilovich points out a myriad of flaws in Human decision making in his seminal work, “How We Know What Isn’t So.” Gilovich makes a very strong case that we are hard wired for self-deception, rationalization, and faulty logic. The human mind tends to bring order from randomness, and the markets are a perfect example of that.

EMH proponents suggest most participants would be better off owning index funds — something I agree with for many time constrained or uninterested investors. By definition, if someone is outperforming, than someone else is under-performing. The odds favor that its more likely to be a small private investor (not that institutional players don’t stink up the joint). Over time, money flees professionals who consistently under-perform. The same ruthless Darwinian competition that drives  pros out of business merely makes lousy individual investors poorer.

Here’s an excerpt from a recent WSJ article discussing Professor Fama’s change in thinking:

“The shift in this long-running argument has big implications for real-life problems, ranging from the privatization of Social Security to the regulation of financial markets to the way corporate boards are run. Mr. Fama’s ideas helped foster the free-market theories of the 1980s and spawned the $1 trillion index-fund industry. Mr. Thaler’s theory suggests policy makers have an important role to play in guiding markets and individuals where they’re prone to fail.

In a study of Sweden’s efforts to privatize its retirement system, Mr. Thaler found that Swedish investors tended to pile into risky technology stocks and invested too heavily in domestic stocks. Investors had too many options, which limited their ability to make good decisions, Mr. Thaler concluded. He thinks U.S. reform, if it happens, should be less flexible. “If you give people 456 mutual funds to choose from, they’re not going to make great choices,” he says.

If markets are sometimes inefficient, and stock prices a flawed measure of value, corporate boards and management teams would have to rethink the way they compensate executives and judge their performance. Michael Jensen, a retired Harvard economist who worked on efficient-market theory earlier in his career, notes a big lesson from the 1990s was that overpriced stocks could lead executives into bad decisions, such as massive over-investment in telecommunications during the technology boom.

Even in an efficient market, bad investments occur. But in an inefficient market where prices can be driven way out of whack, the problem is acute. The solution, Mr. Jensen says, is “a major shift in the belief systems” of corporate boards and changes in compensation that would make executives less focused on stock price movements.”

Your own belief system will help determine which camp you may find yourself in:  If you think that Human Beings are rational, calculating machines, without systematic biases, whose behavior can be predicted with mathematical models, then EMH is for you. If you believe that investors are fallible, emotional, biased and error-prone, than the behaviorist school will be more to your liking.

As someone who has long scoffed at EMH, I particularly enjoyed Yale University economist Robert Shiller’s comments on the subject: EMH proponents have made one huge mistake: “Just because
markets are unpredictable doesn’t mean they are efficient
.” The leap in logic, he wrote in the 1980s, was one of “the most remarkable errors in the history of economic thought.”

Indeed. I doubt it will be the last . . .

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UPDATE:  February 13, 2005 8:48am

I came across an economist joke on point with the ideas in this post:

Seven habits that help produce the anything-but-efficient markets that rule the world by Paul Krugman in Fortune.

1. Think short term.
2. Be greedy.
3. Believe in the greater fool
4. Run with the herd.
5. Overgeneralize
6. Be trendy
7. Play with other people’s money

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Sources:

Stock Characters As Two Economists Debate Markets, The Tide Shifts
JON E. HILSENRATH
THE WALL STREET JOURNAL, October 18, 2004; Page A1  
http://online.wsj.com/article/0,,SB109804865418747444,00.html

Category: Philosophy, Psychology, Really, really bad calls

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

7 Responses to “The kinda-eventually-sorta-mostly-almost Efficient Market Theory”

  1. David Bennett says:

    This theory is falsifiable in so many ways that it clearly proves that economics is not a science.

    Which is too bad. There is some scientific world done in the field, but the credence allowed this idea makes it laughable in field with serious peer review such as biology or physics.

    I don’t find the naiviety “charming” however. I think it encourages some very ugly assumptions that work to the benefit of the status quo and against the “people.”

    One dsiproof (among dozen that come to my head) is that there is no way that I can with any precision measure the “secular bear market” hypothesis. I am aware of counter arguments and can make some myself, but neither I nor anyone no matter how much pseudo mathematics is going to come up with very good numbers. So one can’t even compute that risk into market price.

    One might be able to compute the value added to stocks by the large number of people who don’t know about this hypothesis. I will tell you that people tending towards their fifties will frequently have a notion that stocks have a “real value,” they will worry if they knew p/e was 50% above average historical value. A lot of them would move to bonds figuring that at this price the best stocks are likely to do (on balance) for the next few years is stay roughly steady. So why risk 30% loss.

    But the system doesn’t do a good job of informing these people, the message they are getting is that “for the next few years stocks might only return 6 or 7%.” I don’t make this up, it’s typical advice.

    I happen to believe in the medium or at least long term the market is a relative good measure of value, but it isn’t because of “prediction.” We can’t predict. In a perfect market where all information was known to all players there would stil be different choices built on different needs and judgements.

    For example the common consensus is that the net will increase corporate profits. I hope it will make for a more perfect market which will reward small players and cut margins for the big.

    For example near me is a Mexican grocery. Most of heir vegetables are half those of the supermarkets and their avocados don’t spoil as they ripen. You don’t know about it. But 5 years from now your wife has left a meassage saying you need vegeatables, you happen to be driving 5 blocks from this store, it tells your “system” it’s deals, your system looks it up, it has a good reputaton rating and it also notes there is free parking and the store isn’t busy.

    What happens to Safeway?

    This is what I what to see and I hope it will aply to all kinds of enterprises. But what happens when entry becomes easy, small enterprises can collaborate to act like large ones do now, the electronic infrastructure is such that little guys can do things that now take big bureucracies, and search systems are good enough to let consumers know who is offering what cutting down the value of big advetising?

    It could happen. I wouldn’t hold my breath, but it couldn’t. So one can’t predict medium or long term developments of a technology whose rough physical capacities in the next five years are known. But historically long and medium term trends have been the ones it was possible to predict.

    Short term fluctuations. We see them all the time. Stocks go down on rumors of war. They go up again. “don’t worry they’ve incorporated the risk of war in their price.” War starts, they go down. Or “higher employment figures made stocks fall,” but a few months ago “higher employment figures made stocks rise.” There is always a reason, you can always find a reason, but it is an illusion. An illusion that feeds the fiction that people are getting the information they need.

  2. RichL says:

    Isn’t it something that efficient market theory becomes defunct at the same time that thousands of hedge funds are busily reducing the inefficiencies of the equity market to the point where it’s REALLY HARD for them to make any money from market inefficiencies. If you throw lots of capital and people at any business the excess returns go away. That’s what Wall St. is best at.

  3. David Bennett says:

    Rich L:

    It is also interesting and one positive aspects of hedge funds that some participants are challening the value of private research and arguing that the evolution of new public forms such as blogs will provide a more efficient method of providing information.

    This is certainly one of the reoccuring themes of seekingalpha.com The writer also explains to readers how they can use the functions availible at etrade to automatically rebalance their portfolios and theorizes on the use of ETFs and other tools to let individuals create their personal equivalents of hedge funds.

  4. KarlinCT says:

    What about other gambling?

    Every paper, magazine and TV show has a tout with football picks. The ones who act as if they’re using their own money don’t pick 16 games every week.

    That’s the same as the analysts who “beat the market”. They don’t put $$$ (their own or their investors’) down on every stock listed, or every one of Whichever Big List (Forbes 400, etc). They stick with their comfortable knowledge (or informed guess) and nobody’s making them chase bets.

    Is this so simple an idea that I’m stupid? (Er, don’t answer that.)

  5. Joshua Sharf says:

    It’s the kind of argument only academics could have. Everyone knows that market bubbles happen. And the end of that article says that Thaler has his money in index funds.

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