If Chicago were, say, the world of finance, the efficient market hypothesis would be the Willis Tower. That’s the old Sears Tower, for those who don’t know. As a hulking steel pillar looming over its surroundings, the theory claims that a financial asset’s price reflects every bit of available information related to its value. It is the foundation by which lots of economists tell regular investors they can’t possibly beat the market. After all, how can you figure out a better value for an asset when all the information about it is already wrapped into the current price?
In the world of the EMH, as it is known, bubbles are nothing to seriously worry about because prices cannot deviate from proper valuations for too long. But in the wake of last fall’s stock market collapse, fully embracing the efficient market hypothesis can be a scary proposition – a bit like stepping out on “the Ledge” at the Willis Tower. (An absolute must if you’re in Chicago, by the way.) The events of the past year have sparked a rich debate between behavioral economists and EMH-ers over the the EMH’s validity that is nicely chronicled in this week’s Economist.
“In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”. (Myron) Scholes, however, insists that the efficient-market paradigm is not dead: “To say something has failed you have to have something to replace it, and so far we don’t have a new paradigm to replace efficient markets.” The trouble with behavioural economics, he adds, is that “it really hasn’t shown in aggregate how it affects prices.”
Yet EMH-ers and behaviouralists are increasingly asking the same questions and drawing on each other’s ideas. For instance, Mr Thaler concedes that in some ways the events of the past couple of years have strengthened the EMH. The hypothesis has two parts, he says: the “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.
Read the full piece here.