Markets after the age of efficiency


Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies.

Warren Buffett said most of what you need to know about efficient markets. “Observing correctly that the market was frequently efficient, they [academics, investment professionals and corporate managers] went on to conclude incorrectly that it was always efficient. The difference between the propositions is night and day.”

The difference between these propositions is also the difference between a $50bn fortune and the returns of the average investor. Mr Buffett has made his money not from the part that is frequently efficient, but from the part that is infrequently inefficient.

The efficient market hypothesis has been the bedrock of financial economics for almost 50 years. One of the architects of the theory, Michael Jensen, famously remarked that “there is no other proposition in economics which has more solid empirical evidence supporting it”. Along with other writers of the time – such as Burton Malkiel, whose A Random Walk down Wall Street is now in its ninth edition – Prof Jensen was anxious to dispel the mystique of the financial services industry. Prices followed a random walk, so paying for active management was a waste of money.

Market efficiency is a hypothesis about the way markets react to information and does not necessarily imply that markets promote economic efficiency in a wider sense. But there is a relationship between the two concepts of efficiency. It has long suited market practitioners and rightwing ideologues to encourage such confusion. Since markets are efficient, they argue, interference in markets is counter-productive and more markets mean more efficiency.

As anyone who has taken Finance 101 knows, there are three versions of the efficient market hypothesis. The strong version claims that everything you might know about the value of securities is “in the price”. It is closely bound up with the idea of rational expectations, whose implications have dominated macroeconomics for 30 years. Policy interventions are mostly futile, monetary policy should follow simple rigid rules, market prices are a considered reflection of fundamental values and there can be no such things as asset-price bubbles.

These claims are not just empirically false but contain inherent contradictions. If prices reflect all available information, why would anyone trouble to obtain the information they reflect? If markets are informationally efficient, why is there so much trade between people who take different views of the same future? If the theory were true, the activities it purports to explain would barely exist.

Yet although efficient market theory is not true, it may nevertheless be illuminating. The absurdities of rational expectations come from the physics envy of many economists, who mistake occasional insights for universal truths. Economic models are illustrations and metaphors, and cannot be comprehensive descriptions even of the part of the world they describe. There is plenty to be learnt from the theory if you do not take it too seriously – and, like Mr Buffett, focus on the infrequent inefficiency rather than the frequent efficiency.

The weak efficient market theory tells us that past prices are no guide to what will happen to security prices in future. There is a good deal of evidence for this claim: you would be as well employed studying the patterns on your palm as patterns on charts. But there is also evidence of a tendency for short-term price movements to continue in the same direction – momentum is real. If you know precisely when the short term becomes the long term, this would make you very rich. It is possible to make money – or policy – through reading boom-and-bust cycles. But most participants do not.

The semi-strong version of the theory claims that markets reflect all publicly available information about securities. What is general knowledge will be in the price, so information such as “General Electric is a well-managed company” or “Britain has a large budget deficit”, although correct, is useless to investors. But inside information, or original analysis, might add value.

The strong version of the efficient market hypothesis is popular because the world it describes is free of extraneous social, political and cultural influences. Yet if reality were shaped by beliefs about the world, not only would we need to investigate how beliefs are formed and influenced – something economists do not want to do – but models and predictions would be contingent on these beliefs. Of course, models and predictions are so contingent, and an understanding of how beliefs form is indispensable. Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies. The future of investing – and economics – lies in that more eclectic vision.

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