Posts Tagged ‘efficient market hypothesis’

efficient financial markets?

Sunday, August 23rd, 2015

Economists cannot agree on whether asset markets are efficient or not. This has very important policy implications. Freelance writer Anna Louie Sussman interviews New York University economist Paul Romer for a WSJ blog.

Sussman: Are there any areas where research or refinements in methodology have brought us closer to understanding the economy?

Romer: There was an interesting [2013] Nobel prize in [economics], where they gave the prize to people who generally came to very different conclusions about how financial markets work. Gene Fama at University of Chicago got it for the efficient markets hypothesis. Robert Shiller from Yale got it for this view that these markets are not efficient and subject to too much noise. ….

It was striking because usually when you give a prize, it’s because in the sciences, you’ve converged to a consensus. And it was kind of a prize to economics saying, “You know, you can’t really agree what’s going on in asset markets, but we’ll give a prize anyway.”

Anna Louie Sussman, “Q&A: Paul Romer on ‘Mathiness’ and the State of Economics“, Real Time Economics, Wall Street Journal blog, 17 August 2015.

Most of the interview is about the rise of “mathiness” in economic growth theory. In my opinion, this interview of Paul Romer (born 1955) is of general interest, and should be published in the Wall Street Journal.

HT Mark Thoma.

Blinder on Minsky on the efficient market hypothesis

Friday, February 20th, 2015

[Hyman] Minsky, who died in 1996, may have had the highest ratio of importance to influence of any economist in the twentieth century. He argued for years that financial fragility and recurring cycles of boom and bust (rather than equilibrium) should be the central concepts in theorizing about financial markets and the macroeconomy. Instead of assuming that markets are efficient and expectations are rational, he wrote, economists should assume that markets regularly go to extremes and that people forget. When the profession was being swept by the efficient-market tide, this was deeply contrarian thinking, but I think he was basically correct.

The financial world envisioned by Minsky is different in every respect from the one posited by the efficient-market hypothesis. As long as the good times roll, people lose sight of the bitter lessons of the past, claiming that “this time is different.” Financial excesses grow more severe as bubbles progress, creating greater vulnerability to shocks and more damage when the bubbles finally burst. The crashes themselves always seem to come as surprises, after which sentiment swings radically in the other direction: people shun risk, pessimism rules, and the economy struggles. This all sounds like an accurate description of what happened in the United States and elsewhere between, say, 2000 and 2010. But Minsky is barely mentioned in this volume.?

Alan S. Blinder, “Can Economists Learn? The Right Lessons From the Financial Crisis“, Foreign Affairs (March/April 2015), pp. 154-159 (ungated).

Princeton economist Alan Blinder (born 1945) is reviewing 30 essays presented at an April 2013 IMF conference and published a year later with the title What Have We Learned?: Macroeconomic Policy after the Crisis, edited by George A. Akerlof, Olivier J. Blanchard, David Romer and Joseph E. Stiglitz (MIT Press, 2014).

He has much more to say, mixing faint praise with abundant criticism. He begins with this brief overview:

Is it acceptable for a reviewer to complain about a book’s title? I hope so, because this one is pretty misleading. ….

[R]eaders expecting the insights of 31 prominent authors on what economists should have learned from the crisis may come away disappointed. For example, the book’s index does not even contain the words “bubble,” “subprime,” “Lehman,” or “AIG,” and there is only one reference to derivatives. Still, readers looking for wisdom on how to rethink monetary, fiscal, macroprudential, and other policies will be richly rewarded, for this fine volume is bristling with it.

passive investing and the paradox of efficient markets

Sunday, October 5th, 2014

This weekend brings yet another insightful column from Tim Harford, the “undercover economist”.

Why spend time carefully choosing assets to buy, or lavishly paying active fund managers to do the job for you, when … such returns look so similar to the trained eye that it is pointless to try to pick a winner. Another phrase to describe this idea is the “efficient markets hypothesis”. It is often viewed with suspicion because it sounds a bit Reaganite; in fact, it simply means you shouldn’t be too impressed by people who offer you stock tips. ….

[T]he performance of actively managed investment funds … [on average is no better than] passive funds, which simply try to track some sector or market as a whole …. – particularly not when their fees are deducted. ….

Active managers will have us believe otherwise, and occasional bunfights break out over whether actively managed funds are quite as bad as they seem but, for me, the logic in favour of passive investing is persuasive and the data even more so. ….

[On the other hand] If everybody chose [passive funds] …, there would be no reason to expect a happy outcome. ….

This insight has become known as the Grossman-Stiglitz paradox, after [two economists] …  who back in 1980 … [pointed out] that if financial markets were efficient, there was no benefit in paying for any sort of research or analysis; yet if nobody paid for any sort of research or analysis, why on earth would financial markets be efficient?

We passive investors like to congratulate ourselves on avoiding those parasites, the active fund managers, who charge high fees without delivering high returns. Yet we are parasites too, waiting for others to pay for research and then following the herd. ….

Passive investors shouldn’t feel too badly, though. …. If most investors switched to passive funds …, the market would be full of obvious errors and an active approach would pay off again.

Tim Harford, “Pick a fund, any fund …“, Financial Times, 4 October 2014.

private investment: mind the fees

Saturday, May 10th, 2014

Sorry to harp on this, but I am concerned that so many of my friends and relatives throw away good money by paying large fees to investment managers. Sadly, high fees are also charged by UNFCU Advisors, even though the United Nations Federal Credit Union, like all credit unions, is owned by its members.

The Financial Times has published numerous columns on this subject, all with the same advice. Here is the latest.

If you’re reading this, chances are you’re interested in investing. If so, then it’s likely that your email inbox is bulging with investment ideas – stock tips, thematic pieces on how investing in India or biotechnology will generate huge returns, or profiles of fund managers who can turn water into wine. ….

I was involved in the hedge fund industry for years, and that experience taught me that, from a private investor’s point of view, most of these ideas are not worth following.  I believe the vast majority of investors would be far better off with a process based on the sticking to four principles:

You have no special edge

…. That’s why you pay a fund manager, or a financial adviser. But unfortunately, most of them can’t [select good investments] either ….

Go low – low effort, low cost, low worry

…. Both equity and bond exposure can easily be achieved via exchange traded [index] funds. You can add other government and diversified corporate bonds if you have appetite for a bit more complexity in your portfolio, but even without these it’s very powerful. The bonds control the risk and volatility, the equities deliver the growth.

Think about your specific circumstances

…. Far too many people invest in isolation …. Typically, investors will already have a disproportionate exposure to their domestic economy through their house. They may be heavily exposed to a particular sector courtesy of their job. If you work in IT, you shouldn’t have a portfolio of tech stocks too – it just adds to the concentration risk.

Be a stickler for costs

The portfolio above should only be implemented via extremely cheap index tracking products that charge 0.25 per cent a year or less. …. [S]uppose you are a frugal saver who diligently put aside 10 per cent of £50,000 annual income from the age of 25 to 67. Assume that your investments return 5 per cent a year (this is in line with long-term real equity returns). Consider a typical 2 per cent annual cost difference between an index tracking product and an actively managed fund (including all the extras, not just the management charge). As you get ready to retire at age 67 the difference in the savings pot is staggering. You are left better off by perhaps £250,000 in today’s money simply by investing with an index fund as opposed to an active manager.

Lars Kroijer, “Four principles for stress-free investing“, Financial Times, 10 May 2014.

There is much more at the link.

Lars Kroijer (born 1972) is a Danish national who lives in London. He is author of Money Mavericks: Confessions of a Hedge Fund Manager (FT Press, 2nd Edition, 2012) and Investing Demystified: How to Invest Without Speculation and Sleepless Nights (FT Press, 2014).

See also my recent posts here and here.


Norway’s oil fund

Monday, May 5th, 2014

Norges Bank Investment Management is transferring custodianship of its huge investment portfolio from JPMorgan to Citigroup. Norges Bank is the central bank of Norway. Its oil fund is the world’s largest sovereign wealth fund.

Norges Bank Investment Management … holds on average 1.3 per cent of every listed company globally.

In recent years, the fund has made a concerted push into emerging markets – they now account for about 10 per cent of its $530bn equity portfolio.

The Norwegian fund has investments in 82 countries and 44 different currencies as it seeks to diversify away from what was once the almost total dominance of dollar, sterling, euro and yen assets. It now owns 1.4 per cent of every listed company in the developing world. ….

NBIM prefers its custodian to have proprietary operations in most countries it invests in, rather than having to go through partner banks in more remote regions, which is a more cumbersome process, people close to the decision said.

Citi seen as the most global in the world, with operations in 101 countries. It offers proprietary custodian services in 62 markets.

Daniel Schäfer and Richard Milne, “Citi wins Norway fund business from JPMorgan“, Financial Times, 5 May 2014.

From this article, I learned that Norway does not pay for active management of its equity portfolio. Citigroup, like JPMorgan, is expected to refrain from picking stocks. By purchasing a fixed percentage of each listed company in the world, and rebalancing periodically to restore percentages, the custodian tracks world equity markets, rather than attempt to outperform them.

The underlying investment philosophy can be summed up as follows: (1) Diversify. (2) Keep fees low. Market prices fluctuate. Management fees are constant, and must be paid regardless of a fund’s performance. Active management (attempting to outperform the market) is always more costly than passive management (tracking market returns).

what would Hayek say?

Monday, December 23rd, 2013

Austrian economist Friedrich Hayek (1899-1992) was famously a foe of central planning, and fan of free markets. Nonetheless, Tufts University economist Amar Bhidé is convinced that Hayek would oppose the way free financial markets now operate. (more…)

Robert Shiller on Eugene Fama

Sunday, October 27th, 2013

Professor [Eugene] Fama is the father of the modern efficient-markets theory, which says financial prices efficiently incorporate all available information and are in that sense perfect. In contrast, I have argued that the theory makes little sense, except in fairly trivial ways. Of course, prices reflect available information. But they are far from perfect. Along with like-minded colleagues and former students, I emphasize the enormous role played in markets by human error, as documented in a now-established literature called behavioral finance. ….

Actually, I do not completely oppose the efficient-markets theory. I have been calling it a half-truth. If the theory said nothing more than that it is unlikely that the average amateur investor can get rich quickly by trading in the markets based on publicly available information, the theory would be spot on. I personally believe this, and in my own investing I have avoided trading too much, and have a high level of skepticism about investing tips.

But the theory is commonly thought, at least by enthusiasts, to imply much more. Notably, it has been argued that regular movements in the markets reflect a wisdom that transcends the best understanding of even the top professionals, and that it is hopeless for an ordinary mortal, even with a lifetime of work and preparation, to question pricing. Market prices are esteemed as if they were oracles.

This view grew to dominate much professional thinking in economics, and its implications are dangerous. …. In fact, markets are not perfect, and really need regulation, much more than Professor Fama’s theories would allow.

Robert J. Shiller, “Economic View: Sharing Nobel Honors, and Agreeing to Disagree“, New York Times, 27 October 2013. [subscribe2]

efficient markets hypothesis (EMH) and global recession

Thursday, October 24th, 2013

Many in our profession are upset that Chicago economist Eugene Fama won a third of this year’s Nobel Prize in economics. Here is one example.

Eugene Fama just received a Nobel Prize for his contributions to the theory of “efficient financial markets,” the dominant theory in financial economics that asserts that markets work ideally if not constrained by government regulation. The fact that economic “science” teaches that unregulated financial markets work effectively helped financial institutions and the rich accomplish their goal of radical financial market deregulation in the 1980s and 1990s. Deregulation, in turn, not only contributed to the rising inequality of the era, it helped cause the global financial market crisis that began in 2007 and the deep recession and austerity fiscal policies that accompanied it. ….

The objective of the ideological project of the economics profession in the current era is to provide a theoretical foundation for unregulated financial markets and unregulated capitalism. The fact that the project has succeeded in the face of logic and history is admittedly a fantastic conjurers’ trick, but it is ridiculous to award Nobel Prizes to the conjurers. We should not give prizes to people for the creation and propagation of an ideologically-based theory that strengthened the drive for the radical financial deregulation and thus helped create a global depression.

James R. Crotty, “The Man Who Won a Nobel Prize for Helping Create a Global Financial Crisis“, TripleCrisis, 23 October 2013.

James R. Crotty is a Professor Emeritus of Economics at University of Massachusetts-Amherst.

Thanks to Mark Thoma for the pointer.

Too harsh, you say? Actually, I think the post is not harsh enough. The roots of the financial crisis lie not just in deregulation, but also in government subsidies for risk-taking, a logical outcome of the application of a ‘too big to fail’ mentality to large financial institutions. The result for investment bankers is, when a flipped coin comes up heads, they win. When the coin comes up tails, the taxpayer loses! It is a wonderful game for bankers, who are gambling with other people’s money, but a costly game for taxpayers.

Richard Thaler on the EMH and Trust

Monday, October 21st, 2013

This is a wide-ranging interview. I focus on just two of the topics covered: the Efficient Market Hypothesis (EMH) and the role of trust in a market economy.

The office of behavioural economist Richard Thaler (born 1945) is close to that of the 2013 Nobel laureate Eugene Fama, widely regarded as father of the EMH. The two Chicago professors are close friends, but Thaler, like Yale economist Robert Shiller (also a 2013 Nobel laureate), is a critic of the EMH. Thaler stresses that the Efficient Markets Hypothesis has two parts: 1) There is no free lunch. 2) The price is always right. Although the first component is broadly true, the second is not, Thaler argues.

Regarding trust, Thaler believes that this is essential for economic growth. Free markets alone will not do the job.

Region: What are your thoughts about the EMH today, given the recent financial crisis?

Thaler: Well, I think it’s very hard to argue that real estate prices in Phoenix, Las Vegas and south Florida were rational at the peak. Now, Gene [Fama] will say, correctly, that neither I nor anyone else was able to say when that bubble would break. (I’m not allowed to use the word “bubble” when I’m with Gene.) ….

So when Gene and I have these arguments, he’ll say the fact that you can’t predict when they will end means you can’t say anything about them. I say, no, that’s not the case. And that’s why I separate these two aspects of the efficient markets argument: Whether you can get rich (the “no-free-lunch” part) and whether the “price is right.”

It’s hard to get rich because even though I thought Scottsdale real estate was overpriced, there was no way to short it. Even if there were a way … you might have gone broke before you were right.  ….

But, … most active managers underperform the market. So, I think Gene and I would give similar advice to people, which would be to buy index funds. ….

I think it’s hard to beat the market. Nobody thinks it’s easy, and so that part of the hypothesis is truer, but if we look at what happened to Nasdaq in 2000 [when it fell from 5,000 to 1,400], and then the recent crash [from 2,800 to 1,300 in 2009], well, of course, we’ve never gotten back to 5,000. So it’s very hard to accept that markets always get prices right. ….

Region: One thing we haven’t talked about yet is your work on reciprocity and cooperation. ….

Thaler: ….  It’s very fortunate that we don’t live in a society where everybody is out to take advantage of us. For instance, if you have work done in your house or on your car, there’s absolutely no way for you to monitor what they’re doing, unless you’re willing to spend the time watching them and you happen to know a lot about the work, materials and methods being used.

So it has to involve trust. Trust is really important in society, and anything we can do to increase trust is worthwhile. There’s probably nothing you could do to help an economy grow faster than to increase the amount of trust in society.

Douglas Clement, “Interview with Richard Thaler“, The Region (Federal Reserve Bank of Minneapolis), September 2013.

There is much more in the full interview, including a discussion of Nudge: Improving Decisions about Health, Wealth and Happiness (Yale University Press, 2008), a best-selling book that Thaler wrote with US legal scholar Cass R. Sunstein (born 1954).

Douglas Clement, editor of The Region, interviewed Professor Thaler on 17 July 2013, before the 2013 Nobel laureates in economics were announced.

the “efficient market hypothesis” vs the “cost matters hypothesis”

Sunday, October 20th, 2013

David Henderson’s “A Nobel for the Random Walk of Stock Prices” (op-ed, Oct. 15) describes me as “one high-profile beneficiary of Mr. Fama’s insight,” allegedly inspiring my founding of the Vanguard 500 Index Fund in 1975.

This is untrue. Perhaps to my shame, I didn’t even learn of Eugene Fama’s “efficient market hypothesis” (EMH) until a decade after my creation of the 500 Index Fund. Rather, I was inspired by another Nobel laureate, economist Paul Samuelson, who in his 1974 essay in the Journal of Portfolio Management demanded “brute evidence” that active money managers could beat the market index. Such evidence has yet to be produced.

Numbers-crunching economists like Mr. Fama represent the “quantitative school” of indexing who came to believe in stock-market efficiency. In fact, he inspired the founding of Dimensional Fund Advisors (DFA), which follows, not an indexing strategy, but a strategy based on persistent undervaluations of various market segments. Mr. Fama continues to serve on the DFA board.

The “pragmatic school” of indexing, on the other hand, simply amassed vast statistical evidence showing that the returns earned by active managers seldom outpace the S&P 500 Index. Further analysis showed that the failure of active fund managers was a result of the costs they incurred. The average manager is average, but only before all these fund operating expenses, advisory fees, turnover costs and sales loads. After those costs, active management becomes a loser’s game. It is the “cost matters hypothesis” (CMH) that assures that investors in low-cost index funds win the battle for superior returns.

John C. Bogle, “Eugene Fama and Efficient Financial Market Theory“, letter to the Wall Street Journal, 19 October 2013.

There is more at the link, including a paragraph on another 2013 Nobel laureate, Robert Shiller.

John Bogle (born 1929) founded The Vanguard Group in 1974. Vanguard 500 was the first index fund that the general public was allowed to purchase. Mr Bogle is author of numerous books, including Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor (McGraw-Hill, 1999).

In light of Mr Bogle’s revelation, FT “undercover economist” Tim Harford was wrong to attribute to Eugene Fama ideas that “have helped popularise low-cost, diversified investment and discredit the idea that masters of the financial universe should be richly rewarded for their stockpicking ability”. Paul Samuelson was responsible for this insight and, much later, John Bogle and Robert Shiller for its popularisation.

To his credit, Canadian-born economist and blogger David Henderson apologized for his error.

Thanks for your correction, Mr. Bogle. My apologies for misrepresenting the source of your thinking. Also, thanks for setting up the fund. In my retirement investments, I’ve been a big beneficiary.

David Henderson, “Oops. My Apologies to John Bogle–and to Paul Samuelson“, EconLog, 19 October 2013.