(August 3) – “Back in the 1970’s, the efficient-markets hypothesis was an article of near religious faith. As an economics student, I certainly bought the argument whole,” writes Jeff Madrick in today’s New York Times.
” ‘There is no other proposition in economics which has more solid empirical evidence supporting it,’ Michael Jensen, a leading proponent of this school of thought, concluded in 1978.”
“What the efficient-markets hypothesis principally meant was that you could not beat the market. Economists generally agreed that financial markets processed all new information about securities so efficiently that no one could get a consistent advantage over other investors. In other words, stock prices fairly reflected their true value most of the time. Better to buy an index fund that replicated the broad stock market averages like the Standard & Poor’s 500.”
“But economists are increasingly challenging the orthodoxy. A growing number argue that according to the best new evidence, financial markets do not appear all that efficient after all. My immediate reaction is to wonder how much my eminent professors cost me by convincing me that I could not outperform the averages. An investment of $5,000 in an index fund, earning about 10 percent a year since 1975, would have grown to $50,000 or so by now. But if I had invested with George Soros or Warren Buffett and earned maybe 30 percent a year (delusions of grandeur, I grant, but it serves as an example), that $5,000 would have run up to $3.5 million.”
“In fact, if markets are not as efficient as once thought, there are more important consequences than my personal financial loss. Being less efficient suggests that speculative and dangerous stock market bubbles are entirely possible and even likely, that the federal authorities must remain vigilant about the complete and open flow of information, and that the stock market does not necessarily allocate capital investment to the right places.”
“The best summary of the position is found in a new book, ‘Inefficient Markets’ (Oxford University Press), by the Harvard professor Andrei Shleifer. Mr. Shleifer is no outsider to the economics establishment. He is the recent winner of the John Bates Clark award, given to an outstanding economist under 40. He was an influential proponent of the swift and highly debated introduction of free markets in Russia, known as shock therapy.”
“Make no mistake about the efficient-markets hypothesis. As Mr. Shleifer makes clear, it is a powerful idea. Economists did not argue that all investors had to be rational for the market to work efficiently. Rather, they figured the mistakes of investors often offset one another. More important, even if investors pushed stocks out of line, there were enough well-informed investors who would sell the overvalued stocks and buy the undervalued ones. They would thus set stock prices right again — and, through arbitrage techniques, they would take little risk in doing so.”