Why the efficient markets hypothesis merited a Nobel

FT.com

October 14, 2013 1:35 pm

By Tim Harford

Any follower of Fama would have smelled a rat before the subprime crisis, says Tim Harford
©Bloomberg

Few Nobel-watchers will be surprised at the award of a Nobel Memorial Prize in Economics to Robert Shiller, the man who told us that markets could be irrationally exuberant. He has long been a favourite.

More of a surprise is that Eugene Fama is one of the two men – with Lars Peter Hansen – sharing the prize with Professor Shiller. The old joke about the economics Nobel was that it had been shared by two men who disagreed with each other: Friedrich von Hayek and Gunnar Myrdal. Profs Fama and Shiller, at first glance, are another example: Prof Fama showed that markets were efficient; Prof Shiller showed that they were not.

The idea of efficient markets has taken a pounding over the past few years, so the timing of Prof Fama’s honour seems awkward. I believe that he deserves it.

The belief that financial markets are efficient sounds like some Thatcherite creed but it means something quite different to financial market theorists: that the price of shares today reflects everything we currently know about their value. There are no obvious bargains, no easy forecasts, no get-rich-quick schemes.

More of us ought to know about Prof Fama’s ideas. We would learn that trying to spot a good value share or to make a killing with a buy-to-let property is a bit like trying to pick the fastest queue in the supermarket. If it was so obvious which was the fastest queue, people would get into it and it would not be the fastest queue for long. If he is right and financial markets really are efficient – and the evidence still suggests that they might be – then you and I cannot pick a brilliant investment except by blind luck.

Neither can anyone predict what the market will do tomorrow, because efficient markets already reflect everything we know. Prices change daily only because of news, not because of anything that could have been forecast yesterday. Imagine all the time we could save by ignoring the prognostications of city economists.

Investors who believe in efficient markets make more money – or perhaps I should say lose less money. They do not pay fund managers huge fees to pick good stocks, because they do not think fund managers can pick good stocks. They ignore advertisements touting past performance, because in an efficient market past performance tells you literally nothing about the future. They do not try to time the market, which in practice has always meant rushing in during booms and panic selling during busts – buying high and selling low. In fact, they do not even look at what the stock market is doing from day to day. Why bother? It will not give you an investment edge, and it might well give you an ulcer.

As Prof Fama’s ideas have spread, they have helped popularise low-cost, diversified investment and discredit the idea that masters of the financial universe should be richly rewarded for their stockpicking ability. (To Prof Fama’s credit, he has spent decades searching for exceptions to his own theory – and has found some, notably that small firms produce excess returns after their market valuations fall out of step with their book valuations.)

In the light of the financial crisis, the contribution of Prof Shiller to economic thought is obvious. Prof Fama’s is more subtle: if more investors had taken efficient market theory seriously, they would have been highly suspicious of subprime assets that were somehow rated as very safe yet yielded high returns. Any follower of Eugene Fama would have smelled a rat.

tim.harford@ft.com