The Efficient Markets Hypothesis Comeback

http://www.futureofcapitalism.com/2010/04/the-efficient-markets-hypothesis-comeback

It's become conventional wisdom in the press that the efficient markets hypothesis was somehow disproven by the financial crisis. For an example, see Roger Lowenstein's review in the Washington Post of Justin Fox's book:

The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis. This theory holds that stock and bond markets are nearly perfect -- even during such crazes as the dot-com mania -- and that prices on the exchanges instantly and accurately reflect the available information about publicly traded securities. After the market crash of 1987, Yale University economist Robert Shiller called that belief "the most remarkable error in the history of economic theory." He could have said "most harmful error" as well. Yet it lived on and contributed mightily to the mortgage bust.

For another example, see the book The Road From Ruin, by the U.S. business editor of the Economist, Matthew Bishop, and a former Brotish government official, Michael Green. They write, "The crisis showed conclusively that the efficient market hypothesis is flawed."

So it's more than passingly interesting that Dimensional Fund Advisors, where the father of the efficient market hypothesis, Eugene Fama, is a director and a Web site commentator, is up more than 100% this year, according to a Bloomberg article. It's a little vague for the article whether the 100% number refers to the firm's overall performance or just the performance of one particular bet on mortgage insurers. But if the theory is as erroneous as the critics in the press claim it is, it's worth asking how the investors using it are managing to make so much money?

This whole debate isn't just about the best way to invest money. There's a political strand to it as well; Professor Fama has defined "systemic risk" as "a scare term that governments use to justify bailout actions detrimental to taxpayers." He's also said, "The experiment we never ran is, suppose the government stepped aside and let these institutions fail. How long would it have taken to have unscrambled everything and figured everything out? My guess is that we are talking a week or two. But the problems that were generated by the government stepping in—those are going to be with us for the foreseeable future. Now, maybe it would have been horrendous if the government didn't step in, but we'll never know. I think we could have figured it out in a week or two."

And Clifford Asness, an outspoken libertarian money manager whose views we cover here regularly, got his Ph.D "from the University of Chicago where he was Eugene Fama's student and teaching assistant for two years."

by Ira Stoll  |  Apr 14, 2010 at 12:29 pm Related Topics:  Press receive the latest by email: subscribe to the free futureofcapitalism.com mailing list