Rational Markets?

Today the Nobel Memorial Prize in Economics (which, for the record, started in 1968, and was not among the original prizes established by Alfred Nobel’s will) was awarded for the efficient market hypothesis. The funny thing is, one of the winners, Eugene F. Fama,  is known for establishing the theory, while another, Robert J. Shiller, is famous for arguing against the same idea. The basic idea is that stock markets do a good job of incorporating all available data in pricing shares, to the extent that price movements follow a basically random-walk pattern as new events occur. In the weak form, this means that an individual investor cannot count on obtaining returns above the market rate by studying past prices in an attempt to find a pattern and bet accordingly, since if such a pattern existed, it would be erased by other investors who are also looking as the same data. In the strong form, prices are so perfectly tuned to reflect all information, public and private, to the extent that no one can ever achieve excess returns. Investing is just a matter of luck (random walk), although riskier investments (that is, larger volatility) are rewarded with larger average returns. Shiller, who also lends his name to the Case-Shiller index of house prices, shows some very compelling data that stock prices are much more volatile than would be expected if investors were simply tabulating the present value of a company’s dividends. In what should not be a surprise to anyone, the stock market is susceptible to bubbles, booms, and busts.  [I strongly recommend listening to Prof. Shiller’s lectures at Yale University, available for free on iTunes U]

From a probability point of view, both models are interesting. There is a great deal of mathematical theory on random walks (or martingales) if one subscribes to the efficient market hypothesis. In fact, this view has helped increase interest in index funds, for a simple reason: If you can’t beat the market, just “buy the market” instead of paying someone else to gamble with your money. On the other hand, Robert Shiller’s more realistic assessment shows that stock markets are complex dynamic systems in which effects (rising stock prices) can become their own causes (more buying), so bubbles can be formed out of these vicious cycles. It might seem weird that the committee would honor both points of view.  But this is how science works. It is still useful to think about the efficient market hypothesis even if it is not really true, just as it is useful to consider friction-less surfaces and masses ropes in physics. The ideal model (like all models) is wrong, but may still be a major advance. We should be aware that, if everything is working right, it should be impossible for the average investor to beat the market by being clever, but sometimes systems fail in spectacular ways.

Some have said that the overall message is that we have some hope of predicting the moving of the market over the long term (years), but no chance of predicting  the short term movement (days). Maybe this is a rebuke to the entire financial media industry, that tries to explain why the market moved up or down each session based on this or that piece of news. Adjust your expectations of “predictability” accordingly.

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Author: lnemzer

Assistant Professor Nova Southeastern University

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