Are markets efficient? A discussion between Thaler and Fama

An earlier blogpost reported the award of the Nobel Prize in Economics 2017 to Richard Thaler of the University of Chicago for his work on behavioural economics.

In this video of the Chicago Booth Review, Thaler, a vehement critic of the idea of market efficiency, engages in an interesting discussion with Eugene Fama, another University of Chicago Nobel Prize laureate (2013) and widely regarded as “the father of the efficient-market hypothesis”.

In his previous work, Eugene Fama introduced the model of “efficient capital markets”, i.e. markets that fully reflect all available information (see the paper: “Efficient Capital Markets: A Review of Theory and Empirical Work”). The most common version of this model that is defended today, is the “semi-strong version”, according to which all publicly available information is incorporated in stock prices (but information that is held privately by some investors not necessarily so).

Thaler has spent much of his time writing about how people are not completely rational, an assumption that strongly underpins the efficient-markets hypothesis, for example in his book “Nudge” (together with Cass Sunstein) and in his book “Misbehaving: The Making of Behavioral Economics”.

In the discussion with Fama, Thaler distinguishes two aspects of the efficient-markets hypothesis: “One is whether you can beat the market. The other is whether prices are correct.” On the first aspect, Fama and Thaler are in agreement: generally, even professional mutual fund managers fail to consistently beat the market, after subtracting management costs (Michael Jensen from Harvard University first provided evidence for this hypothesis in this paper).

Fama and Thaler do disagree (and rather strongly) about the second aspect, however. In the video, Fama argues as follows about the efficient-market hypothesis:

“It’s a model, so it’s not completely true. No models are completely true. They are approximations to the world. The question is: “For what purposes are they good approximations?” As far as I’m concerned, they’re good approximations for almost every purpose. I don’t know any investors who shouldn’t act as if markets are efficient. There are all kinds of tests, with respect to the response of prices to specific kinds of information, in which the hypothesis that prices adjust quickly to information looks very good. It’s a model—it’s not entirely always true, but it’s a good working model for most practical uses.”

Thaler, however, refers to the example of Black Monday (19 October 1987), where the stock markets crashed and fell 25% in one day, and says: “I don’t think anyone thinks that the value of the world economy fell 25 percent that day. Nothing happened. It’s not a day when World War III was declared.”

Fama: “It was a time when people were talking about perhaps an oncoming recession, which turned out not to have happened. In hindsight, that was a big mistake; but in hindsight, every price is wrong. […] We know there is variation in expected returns. Risk aversion moves dramatically through time. It’s very high during bad periods and lower during good periods, and that affects the pricing of assets and expected returns.” 

Fama and Thaler seem to disagree about whether certain examples of seemingly irrational behavior constitute evidence or rather “anecdotes”. The key question of course is whether behavioral finance can provide for a better theory to predict market behavior than the efficient-markets model can, for example by providing a systematic way of identifying bubbles. As Fama notes: “I still think there is no full-blown testable behavioral asset-pricing model.” This is problematic, as the efficient-markets hypothesis underpins much of corporate and financial law.

Ronald Gilson and Reinier Kraakman have argued that the efficient-markets hypothesis can be saved, even after the financial crisis (see this paper): “Contrary to the view of many critics, the Efficient Capital Markets Hypothesis (“ECMH”), as originally framed in financial economics, was not “disproven” by the Subprime Crisis of 2007-2008”.

They argue that the claim of “informational efficiency” (i.e. the fact that all public information is incorporated in stock prices) of the efficient-markets hypothesis should not be confused with “fundamental efficiency”, i.e. that stock prices always correspond to the discounted present value of the future cash flows of the stock. Their point is that we can never know what the “fundamental value” of a stock is. Relatively to other methods of measurement, the efficient-markets hypothesis is still the best predictor of the fundamental value of a stock. In other words, “there is no alternative” (yet).

In conclusion, we seem to be stuck with a model (the efficient-markets hypothesis) that is “obviously wrong” on some points, but that is still (relatively speaking) the best predictor of reality. Researchers can use this theory as a starting point, but should try to refine it where possible, using insights from behavioral economists, such as Mr. Thaler.

Tom Vos

Author: Tom Vos

Tom Vos is a visiting professor at the Jean-Pierre Blumberg Chair of the University of Antwerp, where he conducts research and teaching in the field of corporate governance. He is also affiliated as voluntary scientific collaborator with the Jan Ronse Institute (KU Leuven). His current research interest is short-termism in corporate governance.

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