Students have recently been asking about how anyone can continue to defend the efficient markets hypothesis (EMH) against the backdrop of the financial crisis and volatility we’ve seen in the last couple of years.
I think there are two useful ways of looking at this. One is suggested by the famous behavioural economist Richard Thaler, in an article in the Financial Times on August 5, 2009. He summarised the EMH as having two messages: i) no free lunches; and ii) the price is right. The first of these is broadly intact; it is still prudent to assume that you are unlikely to beat the market without a great deal of skill and hard work. But ii) is in some jeopardy, as it is hard to believe that the prices of securities in the last couple of years were always reflecting their true fair value.
Secondly it’s worth revisiting the late Paul Samuelson’s 1998 idea that stock markets are “micro efficient” but “macro inefficient”. Samuelson was one of the greatest of 20th century economists and one who spent enough time in the stock market to be a little sceptical about some of the more extreme EMH ideas. One reason for why the EMH might not hold so well for the whole market is that it cannot be arbitraged in the way that individual stocks can. Here a relevant example is the technology, media and telecoms bubble of the late 1990s (often referred to as the dot-com bubble, but the biggest damage was done in the telecoms sector). Many practitioners correctly saw that we were in a bubble, where valuations were increasingly absurd and money was moving in a speculative way. But nobody knew when it would end and some previously successful hedge fund managers lost a lot of money in being right – but too early.
Interesting Thaler says in his FT article that with all of their flaws, financial markets remain the best way to allocate capital. But we should not assume the price is right.