From the April 2010 issue of Research Magazine • Subscribe!

Efficiently Controversial

The efficient-markets hypothesis has long had fervent advocates and skeptics.

Financial theory is in flux. Ideas that once were widely accepted among financial economists are in dispute. In particular, the efficient-markets hypothesis -- which dominated academic thinking about finance for decades and influenced the investment industry while never fully being embraced by it -- has faced growing skepticism in recent years, and all the more so in the aftermath of the market mayhem of 2008.

The efficient-markets hypothesis, or EMH, holds that the price of a financial asset swiftly and surely reflects information relevant to that asset. Most often applied to a particular type of asset, namely stocks, the EMH suggests there is no way to beat the market through stock-picking skill, at least not with any regularity. Rather, in this view, stock prices move in a "random walk," buffeted by new information that was not available before (and which may be favorable or unfavorable, versus expectations).

Wall Street has long held a profound ambivalence toward such theoretical randomness. The EMH's broad dismissal of stock-picking has rarely generated enthusiasm in an industry built, in no small part, on precisely that activity. However, the EMH gave intellectual impetus to the development of index funds, and also jibed well with Modern Portfolio Theory's emphasis on diversification across sectors and asset classes. In addition, by downplaying concerns about bubbles and misallocations of resources, the EMH offered a basis for regulators to maintain a relatively light hand.

The EMH emerged as a bold new idea in the 1960s, became the dominant paradigm of academic finance in the 1970s and then gradually faced growing opposition over the next few decades. Much debate hinged on just how efficient markets really are and whether possible variations from efficiency constitute minor exceptions to a generally true rule or major holes in an overly abstract doctrine. In recent decades, behavioral finance has emerged as a serious theoretical contender with its emphasis on psychological quirks that could undermine the market's fast and accurate data processing.

Skepticism about the EMH has been heightened by the financial crisis. Wild swings in the prices of assets cast doubt on assertions that market valuations tend to be broadly in line with intrinsic values. Thus, behavioral finance has gotten a boost, as have other theoretical approaches, such as looking more closely at how the institutions involved in financial markets work (or don't work).

Still, whatever emerges from the current intellectual disarray is likely to bear some imprint of the idea that markets are efficient. No alternative approach seems near to producing a comprehensive, agreed-upon view of how markets function, nor a decisively convincing method of beating the market in defiance of efficiency's logic. Plus, the EMH's validity seems to depend partly on people not believing it; if markets are seen as efficient, there's less motivation for the information-gathering that makes them efficient. Paradoxically, then, attacks on the EMH could actually increase its relevance.

In any event, the history of the efficient-markets hypothesis -- both its rise to dominance and its subsequent piecemeal retreat into an unsettled position -- indicate that even highly esoteric ideas from academic finance have an impact on how financial practitioners go about their business far beyond the walls of academia.

Early Glimmerings

As far back as 1900, a French mathematician named Louis Bachelier was looking closely at securities prices and finding that they lack an observable or predictable pattern. As it happened, this work anticipated the math used by Einstein five years later in elucidating the particle behavior known as Brownian motion. But if Bachelier was slightly ahead of his time in physics, he was way ahead of his time in finance, and his "Th?orie de la Sp?culation" languished in obscurity for more than half a century.

In the next few decades, though, a few researchers were pushing in a similar direction. In 1933, economist Alfred Cowles III sorted through massive data to conclude that nobody had been forecasting the stock market accurately. The next year, researcher Holbrook Working published a study showing historic stock prices to be about as useful for prediction as lottery numbers.

Cowles did a 1944 study covering longer time periods and still showing no evidence of anyone knowing how to forecast the stock market. In 1953, British statistician Maurice Kendall looked at equity and commodity prices and found that random moves were "so large as to swamp any systematic effect which may be present."

During the 1950s, mathematician Leonard Jimmie Savage happened across one of Bachelier's works in a library and sent postcards to some friends asking if they'd ever heard of the French thinker. One of those cards went to Paul Samuelson, then a rising young economist who had published a popular textbook. Samuelson would draw on Bachelier's 1900 study as he went on to become a key figure in developing the EMH.

Modern Efficiency

In 1965, Samuelson published a paper "Proof That Properly Anticipated Prices Fluctuate Randomly," sketching out the idea of market efficiency as a formal theory. That same year, University of Chicago economist Eugene Fama published his doctoral dissertation "The Behavior of Stock Market Prices," which delved into market data to argue that equities are indeed an efficient market, which he defined as "a market where, given the available information, actual prices at every point in time represent very good estimates of intrinsic values."

These papers marked a sharp theoretical turn against beliefs widely held by market practitioners. The EMH called technical analysis into question, since historic price charts would not predict random price moves. Furthermore, it flew against the fundamental analysis that Benjamin Graham had argued investors should do to find incorrectly valued securities; as Fama pointed out, if enough astute people were doing such research, the market would get more efficient, correcting valuations quickly.

During the next few years, Fama and others refined the hypothesis. In a 1970 paper, Fama distinguished between three levels of efficiency: a "weak" form, in which securities prices reflect past developments but future price changes may still have some predictability; a "semi-strong" efficiency, in which prices reflect all publicly available information, but those with inside information may still have some advantage; and "strong-form" efficiency, in which prices incorporate all public and inside information.

Over the subsequent decade, positions leaning toward the strong end of the spectrum became commonplace in theoretical circles. In 1978, economist Michael Jensen wrote: "I believe there is no other proposition in economics which has more solid empirical evidence supporting it" than the EMH.

Debate Stirring

In the 1980s, the EMH's intellectual dominance began to erode. A 1980 paper by Sanford Grossman and Joseph Stiglitz, titled "On the Impossibility of Informationally Efficient Markets," raised the question of why market participants would engage in information-gathering if there was no compensation to be had from it. The authors concluded that some market inefficiency must exist to propel prices toward efficiency.

Soon, economists were poking more holes in the EMH. Robert Shiller, among others, gathered data indicating that stock prices exhibit "excess volatility," moving more than could be justified by subsequent changes in dividends. In a 1985 paper titled "Does the Stock Market Overreact?" Werner F.M. De Bondt and Richard Thaler argued that indeed it does, and thus they took an opening step in the new field of behavioral finance.

The EMH has retained many defenders. In 1973, Burton Malkiel published the first edition of A Random Walk Down Wall Street, espousing the EMH as a solid reason for investors to avoid both stock-picking and trusting in advisors who claimed to know how to pick stocks. By the early 21st -century, he was publishing papers arguing that recent academic criticism of the EMH was overstated, and that just as one would expect under the EMH, professional money managers do not outperform market indices.

More than a century after Bachelier discerned randomness in securities prices, there is no academic consensus as to whether he was basically right. By contrast, many of Einstein's proposals have been tested to the satisfaction of most physicists. Finance, it seems, is in some ways a more intractable subject than physics.

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Pick Up That Bill?

An old joke about the efficient-markets hypothesis: An economist is walking down the street with a friend. They see what looks like some money lying on that ground, and the friend moves to pick it up. "Don't bother," says the economist. "If it were real money, someone would have picked it up."

Journalist Daniel Gross wrote in the online magazine Slate recently about coming across what looked like some currency on the floor while attending the World Economic Forum at Davos. Picking it up, he found it was a 10-pound bill, lying untouched in a roomful of profit-maximizing bankers, businesspeople and economists. Gross mused that he had just disproved the efficient-markets idea.

Economist Alex Tabarrok, responding at the blog Marginal Revolution, recalled his own experience picking up some green paper near Wall Street and finding it was a "cleverly folded piece of paper designed to look like money when dropped on the street, although it was actually an advertisement." He added: "Kudos to Eugene Fama, I thought on that day."

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