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What are “efficient markets,” and why it matters

Efficient markets theory - loosely speaking, the idea that a company’s current stock price reflects all available information about its expected long-run profitability and value - has long faced challenges from not only finance practitioners but also academic theorists. Resistance to the idea reached a new level last year when the U.K.’s market regulator cited “the theory of efficient and rational markets” as a major contributor to the global financial crisis.

In one of its simplest versions, the efficient markets hypothesis (EMH) - long taught in the world’s best business schools - says that competition among investors for information about public companies’ current and future profitability should make current stock prices unbiased predictors of their future values. In this sense, it is a simple extension of the “zero profits” theory that economists have applied to competitive product markets.

This does not mean that the current price is always the “right” price. It does suggest, however, that at any given time a company’s stock price is equally likely to go up or down - that stock prices (along with market bubbles and financial crises) are inherently unpredictable. The most widely cited evidence in support of EMH is the large number of studies documenting the failure of the vast majority of professional fund managers to outperform market averages, both in a given year or with any consistency over time. For most investors, this means that the stock market is a “fair game,” and the best investing strategy is to buy shares in an indexed fund.

But where finance academics see highly competitive markets and sophisticated investors, corporate managers tend to see “the vagaries of the market” - price fluctuations with no connections to fundamentals. Managers have not been alone in voicing skepticism about the rationality of market pricing. In December 1996, Fed Chairman Alan Greenspan issued his famous warning about the “irrational exuberance” of market investors. And in early 2000, with the Dow and Nasdaq at all-time highs, this became the title of Yale economist Robert Shiller’s bestseller in which he argued that general overconfidence and “herding behavior” of investors were driving U.S. stock prices well above levels that could be justified by expected dividends and earnings.

Shiller ultimately turned out to be right, although it took a while. Over the next three years, the Nasdaq fell by more than 75% and the Dow lost as much as 40% of its value - and we have seen equally dramatic declines over 2008 and 2009.

So where do we stand today on the question of market efficiency? Can a stock market that loses nearly half its value in less than a year be considered “efficient?” And in what sense, and to what extent, can a theory be culpable for the pain and losses of the past two years?

To answer these questions one has to be clear about what the EMH says and, more important, about what it does not say. Some observers have blamed the EMH for perpetuating the real estate and stock market bubbles, and for failing to alert investors and regulators to the coming crisis. But in the words of New York University finance professor Stephen Brown, “nobody - no practitioner, no academic, and no regulator - had the ability to foresee the collapse of this most recent bubble.” Bubbles tend to be created and perpetuated by people who are too eager to believe that prices can only go higher. In this sense, then, EMH is a theory about the value of humility - of admitting the inability of even the most knowledgeable people, including professional economists and savvy market analysts, to predict future prices. That insight, along with the positive relationship between risk and expected return that is also an important tenet of modern finance, is probably the most important lesson of efficient markets theory.

Viewed in this light, the fate of Lehman Brothers and other large institutions reflects not excessive faith in EMH but the failure to heed the lessons of efficient markets. In the words of University of Chicago economist Ray Ball, “Lehman’s demise conclusively demonstrates that, in a competitive capital market, if you take massive risky positions financed with extraordinary leverage, you are bound to lose big one day—no matter how large and venerable you are.” And as Ball goes on to point out, “If regulators had been true believers in efficiency, they would have been considerably more skeptical about some of the consistently high returns being reported by various financial institutions. In fiercely competitive capital markets, there is a good chance that high returns are attributable to high leverage, high risk, inside information, or dishonest accounting.”

Harvard’s Michael Jensen argued almost 20 years ago that when people and companies can invest and do deals with nothing on the line, we are certain to get bad deals. Two years ago, such “free option” problems could be seen everywhere - from people buying houses with no money down, to banks that originated mortgages with the aim of selling all of them, to private equity firms pulling out equity as quickly as they could. What this means is that instead of introducing layers of complex new regulations - or, more fundamentally, trying to change human nature by eradicating fear and greed - we should spend more time on the much less ambitious but more productive undertaking of getting incentives right.


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