This essay by Eric D. Wanger was originally published in a newsletter for the financial clients of the multifamily office he ran in Chicago. He wrote in 2009, the year the stock market hit its lowest point in the Great Recession, bottoming at a value less than half of its peak.
The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. “Surely, none of this could be happening in a rational, efficient world,” they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”
–Jeremy Grantham, investment strategist, 2009
In the wake of the recent economic turmoil, it has become fashionable to trash the philosophical underpinnings of our financial system. One of the most universally reviled ideas is the efficient markets theory. Justin Fox, in The Myth of the Rational Market, wrote:
The efficient market hypothesis—long part of academic folklore but codified in the 1960s at the University of Chicago—has evolved into a powerful myth…. The theory holds that the market is always right, and that the decisions of millions of rational investors, all acting on information to outsmart one another, always provide the best judge of a stock’s value. That myth is crumbling.
It’s not obvious where this idea that “the market is always right” came from exactly, but it’s not part of the efficient markets hypothesis.
Professor Eugene Fama, in a 1970 paper, defined the efficient markets hypothesis as “the hypothesis that security prices at any point in time ‘fully reflect’ all available information.” “Efficiency” is an abstract concept describing the rapidity and thoroughness with which market prices come to “reflect” (another abstract concept) whatever information is available. In other words, the more completely and instantaneously that market participants use the information they possess, the more “efficient” the market.
EMH, as it is known to finance geeks, seems too esoteric to be worth hating. So do the differences between Episcopalians and Presbyterians, but in 17th century Britain they resulted in the Killing Time. It seems that ideas, even very abstract ones, can become doctrine. People are funny that way.
In its most literal form, EMH is counterintuitive. Under “strong” EMH, for example, it would be impossible for a trader to take advantage of any “mispricings” because they could not, by definition, exist. That is what Fama meant when he said that an efficient market fully reflects all information.
It’s easy to understand why economists, mathematicians and finance theorists found this idea valuable. Like Freud’s theory of the unconscious, Darwin’s use of natural selection, or Galileo’s demonstration that the sun really is in the center, EMH provided a fresh way to look at the world, opening up an area of intellectual and philosophical development. Time turned the authors of EMH into saints and their writings into creeds, just as with Freud, Darwin, Galileo and their ideas. EMH came to be preached, not discussed, leaving little room for doubt or debate. That’s how it was taught to me.
The attacks on the EMH are really attacks on the students and teachers of EMH who have risen to power in finance and government. EMH has come to stand for the arrogance of hedge-fund managers, mortgage brokers and the risk managers at Lehman, Bear Stearns and AIG. That’s why people bash EMH: Our brightest finance students just bankrupted the country. Yet, EMH is just an idea, and ideas don’t do much damage by themselves. Burton Malkiel put it this way in the New York Times:
It’s ridiculous to blame the financial crisis on the efficient market hypothesis. If you are leveraged 33-1, and you’re holding long-term securities and using short-term indebtedness, and then there’s a run on the bank—which is what happened to Bear Stearns—how can you blame that on efficient market theory?
Eugene Fama wrote: “Though we shall argue that the model stands up rather well to the data, it is obviously an extreme null hypothesis. And, like any other extreme null hypothesis, we do not expect it to be literally true.” That’s hardly the position of a zealot.
Remember, Sigmund Freud never actually said, “Sometimes a cigar is just a cigar.”
Eric D. Wanger, JD, CFA