EUGENE FAMA VS. RICHARD THALER --
Are We All Behaviorists Now? Corporate law prof. Stephen Bainbridge takes a look -- and applies some Thaler insights
to the regulators. It looks like we may end up not too far from were we started. (via
The Right Coast). Quotable:
The efficient capital markets hypothesis (ECMH) is one of the most basic -- and influential -- principles of modern corporate finance theory. During the 1980s, for example, the Securities and Exchange Commission (SEC) relied on the ECMH to justify many deregulatory initiatives. In the capital markets, acceptance of the ECMH by investors drove the burgeoning popularity of indexing as an investment strategy. The ECMH's validity thus has enormous implications both for the way in which we invest and how the government will regulate the capital markets. As the Wall Street Journal put it, the debate affects a host of "real-life problems, ranging from the privatization of Social Security to the regulation of financial markets to the way corporate boards are run."
The ECMH's fundamental thesis is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. As applied to stock markets, the ECMH thus has two principal implications. First, stock prices follow a random walk. Put another way, the ECMH predicts that price changes in securities are random. Randomness does not mean that the stock market is like throwing darts at a dart board. Stock prices do go up on good news and down on bad news. Randomness simply means that stock price movements are serially independent: future changes in price are independent of past changes. In other words, investors can not profit by using past prices to predict future prices.
Second, the ECMH posits that current prices incorporate not only all historical information but also all current public information. This form predicts that investors can not expect to profit from studying publicly available information about particular firms because the market almost instantaneously incorporates information into the price of the firm's stock.
The ECMH assumes investors are rational actors whose behavior is consistent with that predicted by the rational choice model. Over the last decade or so, behavioral economists (such as Thaler) have drawn on experimental economics and cognitive psychology to identify systematic departures from rational decisionmaking, even in market settings. Put another way, behavioral economics claims that humans tend to make decisions in ways that systematically depart from the predictions of rational choice.
The ECMH has been one of the behavioralists' favorite targets. Thaler and others have argued that markets are made of human actors, who bring to bear their own individual foibles. Idiosyncratic valuations generate noise that may skew the market's valuation of stock prices. (Just as it is hard to carry on an accurate conversation in a noisy room, it is hard to accurately value stocks in a noisy market.) Research in cognitive psychology suggests that investor idiosyncrasies do not always cancel one another out. Instead, investors sometimes act like a herd all running in the same direction, which can produce pricing errors. Large speculative bubbles that appear out of nowhere and crash without apparent reason are the most visible form of this phenomenon.
The behavioralists have also identified a host of lesser anomalies that are hard to explain in ECMH terms. Stocks tend to suffer abnormally large losses in December and on Mondays. Stocks with low price/earnings ratios tend to outperform the market, as do stocks of the smallest public corporations. Big round numbers (like 10,000) tend to act as psychological barriers. And so on.
References:
Richard Thaler, The Winner's Curse.
Richard Thaler, Advances in Behavioral Finance.
Eugene Fama, Foundations of Finance: Portfolio Decisions and Securities Prices.
Posted by Greg Ransom
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