Fama’s Fallacy
from Peter Dorman
Listen to this excerpt from his interview with John Cassidy:
Back to the efficient markets hypothesis. You said earlier that it comes out of this episode pretty well. Others say the market may be good at pricing in a relative sense—one stock versus another—but it is very bad at setting absolute prices, the level of the market as a whole. What do you say to that?
People say that. I don’t know what the basis of it is. If they know, they should be rich men. What better way to make money than to know exactly about the absolute level of prices.
He makes this point several other times within a few minutes: we know markets are efficient because they are unpredictable.
But those famous monkeys, who sat at their keyboards for centuries hoping to randomly tap out Hamlet, could just as well be inputting unpredictable asset prices.
How can someone be a world famous financial economist and not know the difference between necessary and sufficient conditions?
Update Cochrane too.
Cassidy has him saying:
What efficient markets says is that prices today contain the available information about the future. Why? Because there’s competition. If you think it’s going to go up tomorrow, you can put your money where your mouth is, and your doing it sends (the price) up today. Efficient markets are not clairvoyant markets. People say, “nobody foresaw saw the market crash.” Well, that’s exactly what an efficient market is—it’s one in which nobody can tell you where it’s going to go. Efficient markets doesn’t say markets will never crash. It certainly doesn’t say markets are clairvoyant. It just says that, at that moment, there are just as many people saying its undervalued as overvalued.
To be filed under “not understanding the difference between necessary and sufficient conditions”.
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Real-World Economics Review Blog 
Would not be the principal inneficiency of markets to reflect too acurately the distortions of human behavior, introducing in prices irrational attitudes, inequal distribution of power and richess, interests etc.?
After all it’s called the efficient market HYPOTHESIS, not the efficient market CERTAINTY. It’s an hypothesis in two ways, one of which works and the other does not. It’s an hypothesis in the sense that it says markets (properly designed — and that’s a whole other enigma) set prices for real property better than any other device. It’s been extended also to assert the same about setting prices for not real property. The latter is very difficult to defend, however, since the former is based on open flows of full information among all market participants who are all equally constrained by the same set of rules and laws and fully known to one another. Don’t know how you can assert this is the case with regard to whooly financial markets, for example. In any event those who support the hypothesis claim the results from actual markets bear out the hypothesis. It’s also an hypothesis in the sense that it claims all markets should be presumed to be efficient since they rest on the efficient market hypothesis. Often this is not even taken to be a rebuttable presumption. This use of the phrase (of the representation) simply cannot be justified any way I know of.
No, no, no. It doesn’t “set prices” nor does it do so “better” than any other device. It just tells you that, subject to certain assumptions, prices (set by supply and demand, not by EMH) reflect all known information. Crucially, that information (incorporating the expectations and errors of market participants) may change dramatically (instability is consistent with EMH)
Equally crucially, people may collectively behave in a way that is rational, but wrong. If you believed, in 2004, house prices would continue to rise forever you were wrong, but that doesn’t mean you were irrational to put your money where your mouth was. On the other side, people started shorting mortgage-backed securities in 2005, went bust in 2006 as the boom continued longer than they had expected. Others managed to stay afloat and made a fortune. Who was right? Who was rational. More importantly, was the fact that the first group went bust due to failure of EMH, or due to failure of liquidity?
The assumptions are clearly open to question, but the validity of the hypothesis is not.
People really should understand EMH before they start criticising it. Once you understand it, you realise that it’s a far more bland, yet far more complete, expression of human behaviour than most people think. It doesn’t tell you the market price is right, it does tell you that you’ll have a hard job beating it other than on an inconsistent “gambler” basis.
Only private information gives you an advantage in the market. Now here’s the thing: if you genuinely have better judgement than other participants of the fundamentals related to asset prices, that counts as private information – so let’s say strong-form EMH is false. As Fama says, why aren’t you a billionaire?
Stephan Schulmeister has written interesting things about that: http://stephan.schulmeister.wifo.ac.at/fileadmin/homepage_schulmeister/files/On_the_manic-depressive_fluctuations_of_speculative_prices.pdf
Many of the causes of the financial crisis are entirely consistent with EMH. Only in discarding EMH could people believe such falsehoods as
– houseprices always go up
– by parcelling and re-selling risk, we’ve made it disappear
– “we’ve beaten boom and bust”
– I’m perfectly insured against crisis (even though my assumptions about my counterparty’s future liquidity are entirely baseless).
– All my competitors and business partners are also perfectly insured against risk (even though they all bought their CDS at AIG, just like me)
That all these falsehoods have been “outed” doesn’t “prove” EMH, but it lends a helluva lot of weight to Fama’s case.
As I think he makes very clear, EMH doesn’t suggest that prices are “right” in the sense that last year’s price should be a good guide to today. EMH suggests that prices reflect all available information – prices can be wrong because of surprises.
I’m happy to see we have a defender of the EMH on board, but he/she/J is not responding to the point of this post. At issue is how you would know whether EMH is empirically correct or not, and I am arguing that the unpredictability of price movements is a necessary but not a sufficient condition, despite what the quoted gurus suggest.
In the context you open with, both gurus are rebutting challenges. John Cassidy quotes the ludicrous assertion that EMH sets prices. Both challenges are on the basis that unpredictability of prices are inconsistent with EMH. This is a fatally flawed position – it is sufficient, in this context, to point out the glaring error the challengers are making.
As for EMH being “correct” it’s well known that empirical evidence is unobtainable for 2 reasons:
1. There is a dual-hypothesis problem: in order to decide that the price of an asset today is “correct” we have to know exactly what capital-asset-pricing construct is being used. The CAPM could be wrong, or EMH could be wrong. Alternatively, in hindsight, to say that a price was “correct” a year ago would require you precisely and mathematically to strip out the effects of all unexpected events during that year – somewhat possible at the individual asset view, inconceivable at the market level.
2. Market participants are liquidity-constrained, so their ability to vote with their wallets is bounded.
All we can do is observe the world around us and note that certain aspects of it are highly and repeatedly consistent with semi-strong EMH
– prices are unstable
– fund managers fail consistently to outperform trackers net of management fees
– past performance provides no reliable guide to future performance
I like EMH because it’s consistent with real-world economics. You can’t tell the future. You can develop or acquire more knowledge, but (if that knowledge is worth anything) there will be other people trying to beat you to it. But if, in your arrogance, you think you can tell the future (or if you think you’ve beaten boom and bust – Gordon Brown) – you’ll get shafted.
“The assumptions are clearly open to question, but the validity of the hypothesis is not.”
Short version ‘the validity of the hypothesis is not open to question’ – as befits a true believer.
Apart from many notable economists who did find prices did not reflect underyling value and were warning of the bubble before the collapse. Why can’t we get over this?
“Prices did not reflect underlying value. Why can’t we get over this?”
Because (if true) it tells us precisely nothing about the validity, or otherwise, of the Efficient Markets Hypothesis. The market is an expression of human judgement, which may be (individually and collectively) right or wrong, rational or irrational. If participants are wrong, the market will be “wrong”. It’s like blaming democracy for the fact that Hitler was elected in 1933 – disastrous outcomes for Germany and the world – blame the voters if you like, but don’t blame the mechanism.
The single greatest problem with EMH is use of the word “efficient”, which leads to confusion with economic Efficiency. EMH proponents have never claimed that market prices are always, or even mostly “correct” – we fully acknowledge uncertainty and error in the way participants estimate underlying value.
The danger of dismissing EMH is that you need to provide a better explanation of how to set asset prices. Note that (a) very few economists actually warned of the bubble before the event and (b) some of those had been warning of a bubble for 10 years or more. At what point did they become correct? And why (as I’ve commented before) aren’t they all billionaires? Not to say that these guys were wrong – but looking forward, how should we choose which armchair pundit to be our asset market dictator and take responsibility away from the markets? Especially noting that virtually all politicians and regulators, back in early 2007, joined the bankers in thinking that the market was working fine and everything “correctly” priced.
Here is the problem. If all markets do is take account of all relevant available information, then by definition the EMH is not refutable or supportable by any pattern of asset prices you can observe. By definition, any changes come from the unforeseen, the unknowable. Therefore, only exogenous shocks disturb the system. When these happen, the market dutifully doles out its rewards to those who bet correctly, and justly punishes those who bet wrong.
In short, EMH explains every movement of asset prices by definition. Thus, it explains none of them. This is the implication of the logic of J’s defenses of the EMH.
Thanks Jeff, you are spot on with “it explains none of them”.
Admittedly EMH was hijacked by some mental midgets who DID think that it implied perpetually socially optimal asset pricing e.g. “EMH sets prices better than any other mechanism” – unfortunately, we had one as Chancellor and later PM. Ken disagrees with the Gordon Brown interpretation, and he’s right to do so – but it’s just not what EMH actually says. EMH doesn’t “set prices”; the aggregated decisions of market participants set prices.
In criticising EMH based on empirical asset price evidence, people almost invariably fail to distinguish the conditions of ex ante (uncertainty) and ex post (hindsight). Here’s an example:
Take a coin-toss game. If you bet £1 on heads for a £3 prize, most people would say that’s a pretty good bet. (In fact, you probably won’t find a taker at this price – the market probably clears at 2:1). If tails comes up, as Jeff notes, you get punished because (ex post) you are wrong. No defence that (ex ante) you were “right”. If anyone disagrees, please get in touch as I’d love to gamble against you!
In this simple game, there is very little information, it’s easily understood, there are no external shocks and everyone understands the rules. Participants in asset price markets have to deal with a vast amount more information, which they then use to make their best guess on what the price should be today (with an eye on what they expect it to be next year). Ex ante, they may be right or wrong. Next year (ex post) they may be right or wrong. The right/wrong camps may or may not be the same.
The “market” or the EMH is not “wrong”. Participants are “wrong” ex post – which still (if you think you can disprove EMH based on last year’s asset price) leaves you with the problem of identifying those that were wrong ex ante. In order to do that, you have to KNOW that your asset-pricing model is “correct” as you try to back-calculate last year’s “correct” price from today’s.
@ J
There is an all-important difference between financial markets and a coin toss game: the Likelihood of head or tail is entirely UNAFFECTED by the bets of participants. The outcome of financial markets is DRIVEN by the bets of participants. The example is thus highly misleading.
Thanks Norbert – I disagree.
You’re of course right that the prices in financial markets are driven (ex ante) by the bets of participants, as are the odds in a horse race. The outcomes (ex post) are driven by a combination of unexpected shocks which include, for example, other participants’ changing expectations, and the realisation of their erroneous predictions. Revealed information / knowledge (ex post) about the (ex ante) expectations / errors constitutes the uncertainty that all market participants face ex ante. In short, the bets that others may make are part of the uncertain information set that all market participants must account for.
The example is highly relevant because the original post attacks an EMH fan because he mentions that unpredictable prices are consistent with EMH. My post about the coin-toss highlights that not only can you not tell the future from the past (ring any bells?) but, given our imperfect knowledge of CAPM, you can’t even say much (about asset prices) that’s meaningful about the past based on the present. You can’t “prove” EMH. You can, however, point to colossal evidence that, on the macro-level
a)is entirely consistent with EMH
b)would be colossally improbable if EMH were indeed invalid
EMH detractors are desperate to be able to say “because the price has fallen, it was overvalued”. This completely skates over the two different conditions of ex post and ex ante.
Here is another wrinkle. We are talking about asset prices as if there is one time (ex ante) when all participants buy and sell their assets based on whatever it is they believe – an anticipation of a capital gain, desire to prevent a capital loss, a desire to collect a stream of income over time (dividends), what have you. But asset trades tomorrow affect the value of my trade today. My net worth goes up or down tomorrow if the price of the asset goes up or down tomorrow.
Ex-ante and ex -post are not perfectly discrete times. They are different for each participant. I sell stock because I have been disappointed in performance of the company, (ex post) and I expect it will not improve in the future (ex ante). The buyer expects company performance to be better, so they shell out the dough in anticipation of a capital gain or a larger stream of dividends than the company delivered before. And the price might be lower than she expected to pay. The same transaction captures both expectations and realizations, ex-ante conditions and ex-post conditions, and for both buyer and seller.
Expectations are crucial. They can be disappointed, or come true beyond your wildest dreams (we should all be so lucky?) But Norbert is right. Because of the (mostly) continuous nature of asset trades, the trades themselves drive the future pattern of prices. Not forever, otherwise bubbles would be self-sustaining, but drive them they do.
But stock markets were supposed to fulfill a different function – the allocation of capital to different productive ends. To the extent we talk of capital markets as a casino, a “bubble on the stream of enterprise” (KEYNES) the job of allocation capital is “likely to be ill done” (KEYNES). Efficiency in one sense (you can’t beat the market) means inefficiency in another – mis-allocation of capital.
What we are left with is this. EMH is circular. Of course the collection of human beings has all the relevant information about the future that is available right now. But it is absolutely crucial that different people have different parts of this information in their possession. Thus they will form different beliefs about the future course of events. Some will be very pleased, some will be very disappointed as the future unfolds. The pattern of asset price is also consistent with other ideas, not just the EMH. The pattern of expectations is a possibility, because of the continuous nature of the market as I outlined above.
Thanks Jeff. You say “Ex-ante and ex -post are not perfectly discrete times. They are different for each participant.” Every investment decision, or pricing of assets, has to be made ex ante. Participants have to incorporate the fact (if they are remotely competent) that other participants may influence the price by trading tomorrow. Every evaluation of every investment decision, every historical price we look at, is ex post. Back to EMH – Fama’s critics want to dismiss EMH because (ex post) it looks as though the prices were “wrong”. But the prices were set ex ante. Unless you can state with certainty what the ex ante price should have been at any point in time, you can’t say that the price was “wrong”. You can’t prove nor disprove EMH based on observation of historical prices.
Now you want to talk of capital (mis) allocation. At #9 above I state that the E in EMH has nothing to do with economic allocation. EMH proponents have never claimed that the market participants collectively set prices (ex ante) that are (ex post) socially optimal. What most of us do claim is that nobody (no government, no regulator, no armchair pundit) should necessarily be expected to do better.
Now if you want to tackle capital (mis) allocation – which I’m sure we all do – then I’ll admit, for sure, that laissez-faire markets are imperfect in that they DON’T always ensure that the costs of failure, of poor judgement, sit where they fall. We have just seen a failure of global finance at the systemic level in which taxpayers picked up the tab for bankers’ failures. Regulators have a role in ensuring that market participants are (as in the theory) held accountable for their judgement. (you live by the sword, you die by the sword). In my view, banks shouldn’t be allowed to have so much leverage, creditors should always be in line to take a capital loss, and no bank should be too interconnected to fail. But regulators still can’t intervene directly in asset prices.
Finally you state that “The pattern of asset price is also consistent with other ideas, not just the EMH. The pattern of expectations is a possibility”. Can you tell me about the pattern of expectations? If these expectations, and uncertainty about the way they will change, are not already reflected in market prices (ex ante) then you have private information which is valuable. If that’s true, you should be heading to an online broker to get rich, not blogging about it.