Heads it’s pure skill, tails it’s luck – can the markets really be predicted?
Investors are increasingly realising that cheap index funds trump actively managed funds
Picking stocks: investors have reason to be grateful to devotees of the efficient market hypothesis and behavioural finance. photograph: andrew burton/getty images
Are markets efficient, or are investor actions governed by animal instincts? Is it pointless trying to beat the market, or are stocks prone to systematic pricing errors? Is “buy and hold” good advice, or should investors be wary of bubbles and irrational exuberance?
The recent awarding of the Nobel memorial prize in economics to finance professors Eugene Fama and Robert Shiller raises these questions, and many more. Fama is famous for his belief in investor rationality and the efficient market hypothesis (EMH). Essentially, EMH advocates argue investors quickly price in all relevant information into a stock, that there is a wisdom incorporated into market prices that renders futile attempts to beat the indices.
Shiller, like Prof Richard Thaler and other experts in behavioural finance, argues EMH neglects the role of emotions in investing, that prices are too volatile to conform to some Spock-like vision of investor rationality, and that greed and fear trigger bubbles and crashes, with markets routinely becoming overvalued and undervalued.
Markets may be unpredictable but that doesn’t mean they are efficient, says Shiller; that some investors may be irrational doesn’t mean the market is inefficient, retorts Fama.
“It’s great work,” he once said of Richard Thaler’s behavioural findings, “but there is nothing there.”
Today, that view is a minority one, and Fama’s protestations to the contrary can sometimes be reminiscent of the old joke about the finance professor who refuses to believe his friend’s exclamation that there is a €20 note on the pavement. It can’t be, says the professor – if there was one, someone would have picked it up already.
Fama, Richard Thaler has said, “is the only guy on earth who doesn’t think there was a bubble in Nasdaq in 2000” (Fama argues tech prices were based on “reasonable beliefs at the time that the internet would revolutionise business”). The word bubble “drives me nuts”, he once said, even denying in 2010 that there had been a housing and credit bubble in the US.
Warren Buffett’s quip that he would be “a bum on the street with a tin cup” if EMH was true does not impress Fama, who says he doesn’t know if Buffett “is just lucky or skilful”. Ironically, Fama’s own research shows that small-cap and value stocks outperform, but he attributes this to their supposed extra risk rather than market inefficiency.
Ideological devotion to EMH, say critics, ultimately led to financial carnage. Former Federal Reserve chief Paul Volcker opined that “an unjustified faith in rational expectations [and] market efficiencies” was one of the causes of the global financial crisis. Or, to use an equation devised by value investor Jeremy Grantham: “Greed + Incompetence + A Belief in Market Efficiency = Disaster.”
Unsurprisingly, it is no longer heresy to question the gospel of efficient markets. Deregulator extraordinaire Alan Greenspan last week admitted to being “intellectually shocked” by the events of 2008, admitting he now realised “there is something more systematic about the way people behave irrationally”.
Prof Burton Malkiel, the author of A Random Walk on Wall Street, one of the classic EMH tomes, now describes himself as “a random walker with a crutch” who accepts markets “go crazy from time to time”.
However, EMH’s flaws should not obscure its achievements. Most people would be better off not wasting their time looking for €20 notes on the pavement – someone else usually does get there first. Burton Malkiel’s assertion that a blindfolded monkey throwing darts at the stock pages would do as well as market professionals has been proved right over the last four decades. Only a very small minority of investors ever beat the market, and it is nearly impossible to predict the best performers in advance.