Posts Tagged ‘efficient market hypothesis’

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.

Nobel Memorial Prize in Economics – 2013

Tuesday, October 15th, 2013

The Royal Swedish Academy of Sciences awarded this year’s “Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel” jointly to three economists: Eugene Fama, Lars Peter Hansen and Robert Shiller. Fama, from the University of Chicago, is a father of the “efficient market hypothesis“. Shiller, from Yale University, believes that investors’ behaviour is not fully rational, leading to booms and busts in housing and financial markets. Hansen, also at the University of Chicago, has confirmed empirically Shiller’s conjecture that models assuming rationality cannot explain the ups and downs of asset prices. (more…)

DeLong remembers Friedman

Wednesday, August 14th, 2013

Berkeley economist Brad DeLong (born 1960) recalls conversations with Chicago economist Milton Friedman (1912-2006), a giant of 20th century economics.

In my rare coffees and phone calls with Milton Friedman, I found I could distract him whenever I was losing an argument by saying: “Why is it that the government needs to intervene and keep the flow of liquidity services provided to the economy growing along a smooth path? Why must there be a quantitative target achieved by government for the path of the liquidity services industry–commercial banking–when there must not be a quantitative target for kilowatt hours or freight-car loadings?”

He would chuckle and say it was a hard problem, but that he was confident that someday he or somebody else–maybe even me–would find a good, concise, convincing way of proving the point that a modern economy needed very heavy-handed government intervention in regulating the commercial banking industry but nowhere else. It was, he thought, something about the social waste of unnecessary bankruptcy, the catastrophic consequences of bank failures, debt deflation, and the fact that the price of liquidity services was intimately tied up with the units of account that we used to denominate our web of debt.

Brad DeLong, “Why Did Milton Friedman Think a Modern Economy Needed Heavy-Handed Government Regulation in the Liquidity Services Industry and Nowhere Else?” Brad DeLong’s Semi-Daily Journal, 12 August 2013.

DeLong’s post was prompted by the following comment of Princeton economist Paul Krugman in his newspaper column:

One way to think about [Milton] Friedman is that he was the man who tried to save free-market ideology from itself, by offering an answer to the obvious question: “If free markets are so great, how come we have depressions?” Until he came along, the answer of most conservative economists was basically that depressions served a necessary function and should simply be endured…. Such dismal answers drove many economists into the arms of John Maynard Keynes.

Friedman, however… was willing to… admit that government action was indeed necessary to prevent depressions. But the required government action, he insisted, was of a very narrow kind: all you needed was an appropriately active Federal Reserve. In particular, he argued that the Fed could have prevented the Great Depression — with no need for new government programs — if only it had acted to save failing banks and pumped enough reserves into the banking system to prevent a sharp decline in the money supply.

Paul Krugman, “Milton Friedman, Unperson“, New York Times, 12 August 2013.

It is a sign of our times that conservative economist Milton Friedman is regarded as too interventionist by today’s austerians, who oppose fiscal and monetary stimulus.

Shiller on speculative bubbles

Tuesday, July 23rd, 2013

Yale economist Robert Shiller writes that bubbles are difficult to define, and even more difficult to recognize.

The Oxford English Dictionary defines a bubble as “anything fragile, unsubstantial, empty, or worthless; a deceptive show. From 17th c. onwards often applied to delusive commercial or financial schemes.” The problem is that words like “show” and “scheme” suggest a deliberate creation, rather than a widespread social phenomenon that is not directed by any impresario.

Maybe the word bubble is used too carelessly.

Eugene Fama certainly thinks so. Fama, the most important proponent of the “efficient markets hypothesis,” denies that bubbles exist. As he put it in a 2010 interview with John Cassidy for The New Yorker, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”

In the second edition of my book Irrational Exuberance, I tried to give a better definition of a bubble. A “speculative bubble,” I wrote then, is “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase.” This attracts “a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.” ….

Speculative bubbles do not end like a short story, novel, or play. There is no final denouement that brings all the strands of a narrative into an impressive final conclusion. In the real world, we never know when the story is over.

Robert J. Shiller, “Bubbles Forever“, Project Syndicate, 17 July 2013.

As an example of how bubbles can end in complex ways, Shiller notes that “a major boom in real stock prices in the US after ‘Black Tuesday’ brought them halfway back to 1929 levels by 1930. This was followed by a second crash, another boom from 1932 to 1937, and a third crash.”

John Kay on mark-to-market accounting

Thursday, July 18th, 2013

British economist John Kay has written another excellent, ungated column.

[A]ccounting standards – both IFRS [International Financial Reporting Standards] and the US Generally Accepted Accounting Principles – have moved from “prudence” towards “neutrality” and from “historic cost” to “fair value”. That emphasis implies insistence on marking trading assets to market prices. ….

Concern is often expressed about the difficulty of applying mark-to-market principles when there is no active market. Actually, the larger problem arises when there is an active market. ….

A contradiction lies at the heart of the efficient market hypothesis: if market prices did incorporate all available information about the value of an asset, no one would have an incentive to obtain that information in the first place. The perverse implication of asserting that the market price of one’s assets measures their fair value is that the people best placed to supply information about fair value – the owners – abandon the attempt to make such an assessment in favour of the judgment of traders. And this is not an academic quibble: what happened at Enron, and in the banks, was that trading assets were marked to values that had been established not by people who knew about the contracts or the loans, but by the biased and ill-informed assessments of the traders [my emphasis].

To express reservations about the primacy of mark-to-market principles is not to say that assets are best valued at historic cost. Market prices may often provide insights of relevance to managers and investors. But one can acknowledge that utility without adopting an ideological commitment to the infallible, or at least irrefutable, wisdom of the market. In the past decade, the efficient market hypothesis has been mugged by reality. ….

Accounts have many users and many purposes, and these vary with the nature of the business and the environment in which it operates. The nature and content of appropriate financial information should be a matter for negotiation between the companies that prepare accounts and the parties who use them.

John Kay, “The market is not the best place to set a fair price for assets“, Financial Times, 17 July, 2013.

The published version is available here (behind a metered paywall).

Mankiw on personal investing

Sunday, May 19th, 2013

Harvard economist Greg Mankiw has an excellent column in today’s New York Times. I agree with everything in it. So will most economists who read it, but investors rarely listen to us. ‘Expert’ money managers openly despise us. (“Dislike” is too weak a word!)

[W]e economists have written countless studies about the stock market. Here is a summary of what we know:

THE MARKET PROCESSES INFORMATION QUICKLY. One prominent theory of the stock market — the efficient markets hypothesis — explains how answering my mother’s question would be a fool’s errand. If I knew anything good about a company, that news would be incorporated into the stock’s price before I had the chance to act on it. Unless you have extraordinary insight or inside information, you should presume that no stock is a better buy than any other.

This theory gained public attention in 1973 with the publication of “A Random Walk Down Wall Street,” by Burton G. Malkiel, the Princeton economist. He suggested that so-called expert money managers weren’t worth their cost and recommended that investors buy low-cost index funds. Most economists I know follow this advice.





If I could pick just one stock for someone to buy, what would it be? I would now suggest something like the Vanguard Total World Stock exchange-traded fund, which started trading in 2008. In one package, you can get low cost and maximal diversification. It may not be as exciting as trying to pick the next Apple or Google, but you’ll sleep better at night.

N. Gregory Mankiw, “Economic View: What Stock to Buy? Hey, Mom, Don’t Ask Me“, New York Times, 19 May 2013.

Mankiw is applying the term “efficient markets hypothesis” to micro efficiency (inability to predict the future price of individual stocks). Macro efficiency (rational expectations and efficiency of the financial market as a whole) does not follow from micro efficiency. Yes, there are booms and busts in financial markets. If you were able to buy at the trough (when everyone want to sell!) and sell at the peak (when everyone wants to buy!), you would become wealthy. This strategy, as Mankiw explains in this column, is not feasible because of our “ignorance about what moves the market”.

the high and growing cost of financial services

Sunday, May 12th, 2013

Princeton University economist Burton Malkiel has written an essay on the inefficiency and high cost of US financial services. It is his contribution to a Journal of Economic Perspectives (JEP) symposia on “The Growth of the Financial Sector”. Here is the abstract: (more…)

has finance grown too large?

Wednesday, April 10th, 2013

The question refers to the size of the entire financial sector of the United States, not to individual firms operating in it.

[There is] a broader issue that [Federal Reserve] Chairman Bernanke could not possibly mention in these lectures or elsewhere, but that I wish Professor Bernanke would think about whenever he leaves office. Any complicated economy needs a complicated financial system: to allocate dispersed capital to dispersed productive uses, to provide liquidity, to do maturity and risk transformation, and to produce market evaluations of uncertain prospects. If these functions are not performed adequately, the economy cannot produce and grow with anything like efficiency. Granted all that, however, the suspicion persists that financialization has gone too far.

What would that mean? It would mean that the last x percent of financial activity absorbs more resources (especially intellectual resources) and creates more potential instability than its additional efficiency-benefits can justify. This charmingly subversive suggestion is easy to make, but it is extremely difficult to validate. Yes, it is hard to imagine that the Hedge Fund Operator of the Year does anything that is remotely socially useful enough to justify the enormous (and lightly taxed) compensation that results; but that is not really an argument. Much more significant is the fact that the bulk of incremental financial activity is trading, and trading, while it may provide a little useful public information about market opinion, is largely a way to transfer wealth from those with inferior information and calculation ability to those with more. There is no enhancement of economic efficiency to speak of. This is, you might say, the $64 trillion question. Maybe I shouldn’t wish it on Ben Bernanke.

Robert M. Solow, “How to Save American Finance from Itself – Has financialization gone too far?“, New Republic, 8 April 2013 (free access).

MIT economist Robert Solow is reviewing a new book by Ben Bernanke, titled The Federal Reserve and the Financial Crisis (Princeton University Press, 2013). The book is a transcript of four lectures Bernanke gave in 2012 as part of an undergraduate course at George Washington University. Solow (born 1924) won the Nobel Memorial Prize in 1987.

The excerpt above is the conclusion of a very long review.


rational expectations and efficient markets

Wednesday, February 13th, 2013

Edmund Phelps does not think much of rational expectations, the notion that private investors process all available information, so form generally correct expectations regarding the economy.

Q: In the world envisioned by rational expectations, there would be no hyperinflation, no panics, no asset bubbles? Is that right?

A: When I was getting into economics in the 1950s, we understood there could be times when a craze would drive stock prices very high. Or the reverse: An economy in the grip of weak business confidence, weak investment, would lead to loss of jobs in the capital-goods sector. But now that way of thinking is regarded by the rational expectations advocates as unscientific.

By the early 2000s, Chicago and MIT were saying we’ve licked inflation and put an end to unhealthy fluctuations –- only the healthy “vibrations” in rational expectations models remained. Prices are scientifically determined, they said. Expectations are right and therefore can’t cause any mischief.

At a celebration in Boston for Paul Samuelson in 2004 or so, I had to listen to Ben Bernanke and Oliver Blanchard, now chief economist at the IMF, crowing that they had conquered the business cycle of old by introducing predictability in monetary policy making, which made it possible for the public to stop generating baseless swings in their expectations and adopt rational expectations. My work on how wage expectations could depress employment and how asset price expectations could cause an asset boom and bust had been disqualified and had to be cleansed for use in the rational expectations models.

Q: And how has that worked out?

A: Not well!

Caroline Baum, “Expecting the Unexpected: An Interview With Edmund Phelps”, Bloomberg View, 11 February 2013.

There is more at the link. Columbia University economist Edmund Phelps (born 1933) won the 2006 Nobel Memorial Prize for “his analysis of inter-temporal tradeoffs in macroeconomic policy”.

HT Mark Thoma