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

Eric has nearly 30 years of experience as a creative and entrepreneurial professional in roles ranging from general management, team leadership and project management to technical rolls in IT, software development financial services and law. He has run business units, managed teams and delivered projects for established global enterprises and as the founder of a number of startups. Over his nearly 30 years at work, his job titles have included Board Member (public, private and non-profit), President, Founder, Chief Operating Officer, Director of Research, Chief Investment Officer, Fund Manager, Software Developer, Securities Analyst, Web Designer, Systems Integrator, Investment Advisor, Fundraiser, Consultant and Attorney. As a software consultant, cloud based, mobile app software as a consultant to one of the world’s leading electronic medical records companies (Cerner). As Chief Investment Officer and Director of Research for a startup financial services firm (Wanger OmniWealth, LLC), he developed a proprietary, risk-based holistic reporting platform for wealthy families and a set of allocation models based on it. He has developed automated trading systems for equity and equity ETF's. Between 2002 and 2013, Eric served as a portfolio manager of the Long Term Opportunity fund (small/micro-cap equities), the Alternative Fixed Income Fund (blend of exchange traded and privately negotiated debt) and as the strategist and founder (with Ralph Wanger) for the Income and Growth Fund (multi-asset class dividend strategy). Eric was a senior investment analyst at Barrington Research Associates (Chicago) covering technology and business services. Prior to that, Eric was a software, communications, and technology analyst for the Edgewater Funds, a private equity/venture capital firm with over $1 billion under management. Before joining Edgewater funds in 2000, Eric worked in Silicon Valley providing consulting, training, and software development to early-¬stage firms. Between 1991 and 1996, Eric was a principal consultant at EDW, Ltd, a firm he founded to provide software development, training in rapid software development techniques (NeXT), and systems interoperability consulting services for large multi-vendor and distributed computer networks. EDW's clients included such companies as Fannie Mae, MCI, Swiss Bank Corp (UBS), Chrysler, Merrill Lynch, Apple Computer, Stanford University, and The Acorn Funds. Eric received his J.D. from Stanford Law School and is a member of the California Bar. He was co-founder and managing editor of the Stanford Technology Law Review. Eric was awarded a National Merit Scholarship in 1981. He holds a B.S. in Mathematics from the University of Illinois at Urbana-¬Champaign and received a Chartered Financial Analyst designation in 2005. Eric lives in Chicago with his three children and a fat English Labrador retriever named Casper. He enjoys classical and jazz piano, hiking and aviation. He is an instrument rated pilot. Eric serves as a trustee for the Acorn Foundation and is active at Chicago’s Museum of Science and Industry.

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