“I guess we’re all behaviorists now”
One of the most widely believed theories on Wall Street is the Efficient Market Hypothesis (EMH). Adherents of this charmingly naive thesis believe that markets are an incredibly effective distributor of information. Because of this, say EMH theorists, it is impossible, therefore, to beat the market, because prices already incorporate and reflect all relevant information.
Given the random nature in which market and company information comes to investors, and the assumption that prices react/adjust almost immediately to reflect this information, no one can consistently outperform the market over time.
Or so goes the theory.
The thesis has two problems: 1) Many fund managers and investors HAVE outperformed the market. Theorists have never come up with an adequate response to this reality, claiming instead that chance or mere short term market swings explain the out-performance; and 2) it imbues the market with an almost mystical ability to disseminate information, regardless of the emotions and analytical failures of its human participants.
Now Eugene Fama, the father of the EMH, has surprised much of the academic world. At a conference honoring Professor Fama last month, he presented a paper that made the case that poorly informed investors could theoretically lead the market astray; Stock prices, he noted, could become “somewhat irrational.”
Are you suggesting that people may a times be irrational? Shocking!
What the good professor is finally acknowledging is the inherent fallibility of mortal investors. Human beings are highly imperfect organisms as investors. They are impatient, given to bouts of fear and greed, make analytical errors, suffer from bad data interpretation, overrate their own abilities. And that’s before we get to POS (plain ole stupid).
Thomas Gilovich points out a myriad of flaws in Human decision making in his seminal work, “How We Know What Isn’t So.” Gilovich makes a very strong case that we are hard wired for self-deception, rationalization, and faulty logic. The human mind tends to bring order from randomness, and the markets are a perfect example of that.
EMH proponents suggest most participants would be better off owning index funds — something I agree with for many time constrained or uninterested investors. By definition, if someone is outperforming, than someone else is under-performing. The odds favor that its more likely to be a small private investor (not that institutional players don’t stink up the joint). Over time, money flees professionals who consistently under-perform. The same ruthless Darwinian competition that drives pros out of business merely makes lousy individual investors poorer.
Here’s an excerpt from a recent WSJ article discussing Professor Fama’s change in thinking:
“The shift in this long-running argument has big implications for real-life problems, ranging from the privatization of Social Security to the regulation of financial markets to the way corporate boards are run. Mr. Fama’s ideas helped foster the free-market theories of the 1980s and spawned the $1 trillion index-fund industry. Mr. Thaler’s theory suggests policy makers have an important role to play in guiding markets and individuals where they’re prone to fail.
In a study of Sweden’s efforts to privatize its retirement system, Mr. Thaler found that Swedish investors tended to pile into risky technology stocks and invested too heavily in domestic stocks. Investors had too many options, which limited their ability to make good decisions, Mr. Thaler concluded. He thinks U.S. reform, if it happens, should be less flexible. “If you give people 456 mutual funds to choose from, they’re not going to make great choices,” he says.
If markets are sometimes inefficient, and stock prices a flawed measure of value, corporate boards and management teams would have to rethink the way they compensate executives and judge their performance. Michael Jensen, a retired Harvard economist who worked on efficient-market theory earlier in his career, notes a big lesson from the 1990s was that overpriced stocks could lead executives into bad decisions, such as massive over-investment in telecommunications during the technology boom.
Even in an efficient market, bad investments occur. But in an inefficient market where prices can be driven way out of whack, the problem is acute. The solution, Mr. Jensen says, is “a major shift in the belief systems” of corporate boards and changes in compensation that would make executives less focused on stock price movements.”
Your own belief system will help determine which camp you may find yourself in: If you think that Human Beings are rational, calculating machines, without systematic biases, whose behavior can be predicted with mathematical models, then EMH is for you. If you believe that investors are fallible, emotional, biased and error-prone, than the behaviorist school will be more to your liking.
As someone who has long scoffed at EMH, I particularly enjoyed Yale University economist Robert Shiller’s comments on the subject: EMH proponents have made one huge mistake: “Just because
markets are unpredictable doesn’t mean they are efficient.” The leap in logic, he wrote in the 1980s, was one of “the most remarkable errors in the history of economic thought.”
Indeed. I doubt it will be the last . . .
UPDATE: February 13, 2005 8:48am
I came across an economist joke on point with the ideas in this post:
Seven habits that help produce the anything-but-efficient markets that rule the world by Paul Krugman in Fortune.
1. Think short term.
2. Be greedy.
3. Believe in the greater fool
4. Run with the herd.
6. Be trendy
7. Play with other people’s money
Stock Characters As Two Economists Debate Markets, The Tide Shifts
JON E. HILSENRATH
THE WALL STREET JOURNAL, October 18, 2004; Page A1