EMH

Why the efficient markets hypothesis merited a Nobel, by Tim Harford

FT Undercover Economist 14 October, 2013

Few Nobel-watchers will be surprised at the award of a Nobel Memorial Prize in Economics to Robert Shiller, the man who told us that markets could be irrationally exuberant. He has long been a favourite.

More of a surprise is that Eugene Fama is one of the two men – with Lars Peter Hansen – sharing the prize with Professor Shiller. The old joke about the economics Nobel was that it had been shared by two men who disagreed with each other: Friedrich von Hayek and Gunnar Myrdal. Profs Fama and Shiller, at first glance, are another example: Prof Fama showed that markets were efficient; Prof Shiller showed that they were not.

The idea of efficient markets has taken a pounding over the past few years, so the timing of Prof Fama’s honour seems awkward. I believe that he deserves it.

The belief that financial markets are efficient sounds like some Thatcherite creed but it means something quite different to financial market theorists: that the price of shares today reflects everything we currently know about their value. There are no obvious bargains, no easy forecasts, no get-rich-quick schemes.

More of us ought to know about Prof Fama’s ideas. We would learn that trying to spot a good value share or to make a killing with a buy-to-let property is a bit like trying to pick the fastest queue in the supermarket. If it was so obvious which was the fastest queue, people would get into it and it would not be the fastest queue for long. If he is right and financial markets really are efficient – and the evidence still suggests that they might be – then you and I cannot pick a brilliant investment except by blind luck.

Neither can anyone predict what the market will do tomorrow, because efficient markets already reflect everything we know. Prices change daily only because of news, not because of anything that could have been forecast yesterday. Imagine all the time we could save by ignoring the prognostications of city economists.

Investors who believe in efficient markets make more money – or perhaps I should say lose less money. They do not pay fund managers huge fees to pick good stocks, because they do not think fund managers can pick good stocks. They ignore advertisements touting past performance, because in an efficient market past performance tells you literally nothing about the future. They do not try to time the market, which in practice has always meant rushing in during booms and panic selling during busts – buying high and selling low. In fact, they do not even look at what the stock market is doing from day to day. Why bother? It will not give you an investment edge, and it might well give you an ulcer.

As Prof Fama’s ideas have spread, they have helped popularise low-cost, diversified investment and discredit the idea that masters of the financial universe should be richly rewarded for their stockpicking ability. (To Prof Fama’s credit, he has spent decades searching for exceptions to his own theory – and has found some, notably that small firms produce excess returns after their market valuations fall out of step with their book valuations.)

In the light of the financial crisis, the contribution of Prof Shiller to economic thought is obvious. Prof Fama’s is more subtle: if more investors had taken efficient market theory seriously, they would have been highly suspicious of subprime assets that were somehow rated as very safe yet yielded high returns. Any follower of Eugene Fama would have smelled a rat.

How to make money from a Nobel cause

By Tim Harford, UNDERCOVER ECONOMIST, October 25, 2013

At last, they’ve given out a Nobel memorial prize in economics for something that could make money for you and me. Eugene Fama and Robert Shiller have, between them, saved me many thousands of pounds. (Lars Peter Hansen, who shared this year’s prize with Fama and Shiller, developed statistical techniques that, I’m sad to report, have never made me a penny.)

There have been practical prizes before, of course. Only last year, Al Roth shared in the prize, in part for his work designing ways in which possible kidney donors and recipients could be matched with each other for maximum advantage. Ronald Coase, who won in 1991 and died this September, inspired markets to control pollution. And Thomas Schelling, a winner in 2005 for his wily and practical take on game theory, arguably helped prevent the cold war turning into something more catastrophic.  But hard cash in my pocket is something else. And the odd thing is, Fama and Shiller disagree with each other.

Fama’s most famous contributions have been in refining and testing the idea of efficient financial markets. The efficient markets hypothesis, or EMH, is much maligned, so let me state it in the form that has spared me anxiety and saved me money over the years: it’s hard to beat the market, and you should probably be suspicious of people who claim to be able to pull off the trick. As Fama himself told me in a rare interview for the BBC last week: “People spend lots of money … trying to hire managers that can pick stocks although the evidence says quite conclusively that that is probably impossible to do.”

But let’s consider two reasons why we should treat the EMH with scepticism. The first is that it may have led regulators astray by encouraging them to leave markets alone when they should have intervened. Maybe the EMH is a better guide for investors than it is for regulators – although I feel allowing excessive leverage was the ultimate regulatory sin before the crisis, and one not closely connected with the EMH.

But a second reason to disbelieve the EMH is the experience of the dotcom and subprime bubbles. “I don’t even like the word,” says Fama. “If your meaning of the word bubble is that prices went up and then went down, that’s fine. But if your meaning of the word is that prices went up and then it was predictable that they would go down, then I don’t think there’s any evidence to support that.”

Shiller would disagree. He is the pioneer of “behavioural finance” – putting psychological factors back into a study of market behaviour. And a single graph drawn by him saved me from being swept up in the dotcom mania.

Shiller simply plotted a standard measure of stock market valuation – the price/earnings ratio – but rather than looking at a single year’s earnings he looked at average earnings over a decade. The resulting graph showed a huge peak in 1929 – just before the Wall Street crash – that is unique in market experience between 1880 and 1995. Then in the late 1990s, a far larger peak built. In 2000, I showed this graph to many people – and stayed out of the market. It saved me a lot of money.

Of course, it is hard to reconcile Shiller’s conclusions with Fama’s. But when I spoke to Shiller last week, he summed up the tension rather well: “It’s a little bit like religion, you know. There’s all these different sects and, when you look at them in the whole, it doesn’t seem to make any sense, they contradict each other so fundamentally. But maybe there’s some wisdom about living that comes out of all of them.”

That may sound a little far out but in my experience it has proved absolutely true.

Pick a fund, any fund…, by Tim Harford

FT Undercover Economist 4 October, 2014

The supermarket checkout poses a frustrating puzzle. Which line to choose? The one with fewest people? Pah! An amateur’s mistake. One must first look at the number of goods in each shopping trolley to get a sense of how long each person in the queue will take. Elevating the analysis a little further, consider awkward items such as crisps (hard to read the barcode), fruit and vegetables (which must be weighed), alcohol (requiring proof of age). A still higher form of thought is to evaluate the shoppers themselves. Will they fiddle for change? Pull out a cheque book or a wad of coupons and vouchers? If so, avoid.

Yet expending all this mental energy is the mark of a mediocre mind. The truly sophisticated thinker – an economist, for example – knows that there is no need to waste effort. Since others are keenly searching for the shortest queue, there won’t be a shortest queue at all. Each opportunity will immediately be filled, and each line will on average take the same amount of time. Pick a queue at random. Any will do, for they are all much the same.

This is also the case for passive investment. Why spend time carefully choosing assets to buy, or lavishly paying active fund managers to do the job for you, when every asset’s expected risk-adjusted return is the same?

All this assumes something rather important: that the risk-adjusted return (or the length of the queues) is indeed the same. Or at least that such returns look so similar to the trained eye that it is pointless to try to pick a winner. Another phrase to describe this idea is the “efficient markets hypothesis”. It is often viewed with suspicion because it sounds a bit Reaganite; in fact, it simply means you shouldn’t be too impressed by people who offer you stock tips.

We don’t know for sure that all financial assets have the same expected returns after appropriate adjustments for risk, partly because it is not clear what an appropriate adjustment for risk would be. It seems likely that they’re not far off.

One indicator of this is the performance of actively managed investment funds versus passive funds, which simply try to track some sector or market as a whole. Most active managers in most time periods do not manage to outperform passive funds – particularly not when their fees are deducted. As a matter of arithmetic, the average investor cannot beat the market because the market is the average of all the investors. But we might still expect that skilled active managers would consistently beat the average, and most of them cannot. Apparently skilled active managers often see their performance ebb over time, and for every Warren Buffett there are many one-hit wonders in the investment world.

What is more, active management is expensive. Even if you believe that an adviser could pick a faster-than-average supermarket queue to join, you might well be worse off pausing for a couple of minutes to take this advice, rather than choosing randomly without delay.

Active managers will have us believe otherwise, and occasional bunfights break out over whether actively managed funds are quite as bad as they seem but, for me, the logic in favour of passive investing is persuasive and the data even more so.

As this insight becomes better and better publicised, traditional fund managers are losing market share to low-cost exchange traded funds (ETFs) and, at the luxury end, to private equity groups. (The attraction of private equity is that you don’t shop in the supermarket at all. Whether the personal service at the delicatessen is actually worth what it costs is another question.)

I must confess, though, to a twinge of guilt – not a common emotion for the working economist. By passively investing or randomly choosing a supermarket queue, am I not taking advantage of the hard work of others? If everybody chose the first queue or investment that they came across, there would be no reason to expect a happy outcome. It is only because others are taking such pains to choose that I don’t have to bother.

This insight has become known as the Grossman-Stiglitz paradox, after Sanford Grossman and Nobel Memorial Prize winner Joseph Stiglitz, who back in 1980 published a paper pointing out that if financial markets were efficient, there was no benefit in paying for any sort of research or analysis; yet if nobody paid for any sort of research or analysis, why on earth would financial markets be efficient?

We passive investors like to congratulate ourselves on avoiding those parasites, the active fund managers, who charge high fees without delivering high returns. Yet we are parasites too, waiting for others to pay for research and then following the herd. Little fleas have lesser fleas, and so on, ad infinitum.

Passive investors shouldn’t feel too badly, though. This is a self-correcting problem. If most investors switched to passive funds, or picked supermarket queues at random, the market would be full of obvious errors and an active approach would pay off again.

I am beginning to make a study of supermarket queues already. It’s just a hobby – for now.