Another Victim Of The Financial Crisis ...

October 20, 2009

Another Victim Of The Financial Crisis The financial turmoil of the past two years threatened the world’s economies and markets; it also threatened theories that many believed supported markets and finance. At the top of the list of things we used to believe in is the efficient market hypothesis—the idea that markets are so complete and perfect that they incorporate all known information into stock prices so the prices are always correct. It follows that because there is nothing the market doesn’t know, there is no other information available to anyone who could predict future stock prices and beat the market. Moreover, since new information arrives in a random unpredictable fashion, and since changes in stock prices depend on new information, stock prices must be random. These ideas grew up gradually over several decades and were largely codified as modern financial theory over the last 50 to 60 years.

The EMH, as the efficient market hypothesis was nicknamed, became part of the received wisdom of finance—widely taught and rarely questioned. This approach to investing led in two directions. First, the EMH joined with ideas that markets provide the best answers to numerous questions about determining values and setting prices. A corollary is that regulations that interfere with markets or shift prices are mistaken or worse. Second, as the EMH’s formal description took on mathematical elegance, it sped the growth of formal mathematics within finance.

In the last year or two, the objections to the EMH have become louder and more aggressive. Looking back on the current financial crisis, people are asking how the prices could have been “correct” all the time if the market doubled from 2002 to 2007 and then dropped by more than half in 18 months; and how home prices could have been correct if they appreciated by three times in five years before crashing. Certainly there must have been some information that the market missed at the top—something like the emperor’s fabled “new clothes” that, when recognized, changed things dramatically. While the events of the last two years seem, for the moment, to have sunk the EMH, there are challenges going back over two or three decades. A few that deserve mention are research showing that stock prices are far too volatile to be determined only by information on dividends; that there are times when arbitrage is limited and markets can’t adjust to information; in addition to arguments that if the market is efficient, no one will pay to gather the information and the efficiency will be lost.1

Exploring either the financial crisis or the efficient market hypothesis could easily consume this entire journal, not just this short column. Rather than a complete review, the next few paragraphs focus on a few aspects of the recent developments—saving some good things from the EMH’s demise, understanding where the simplification in the math became oversimplification and asking what financial economics should aspire to.

The Cliffs Notes version of the EMH is that you can’t beat the market and therefore the only way to invest is to index. Whatever happens to ideas of market efficiency, indexing will continue to prosper. The success of indexing depends on two things, neither of which depend on market efficiency—if anything, market inefficiency might make indexing more attractive. First, it is difficult to beat the market. Standard & Poor’s SPIVA reports, which compare mutual funds to our indices, consistently show that only two-fifths of the funds, or less, outperform over any three-year period.2 Second, as Bill Sharpe and Jack Bogle have both noted, low fees rather than market efficiency are the key to the success of indexing.

 

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