Nobel Prize - Fama vs. Shiller
So the Nobel Prize winners this year are Robert Shiller, Eugene Fama and Lars Peter Hansen.
What's intersting is that Fama and Shiller could not be more different in their theories.
Fama is the founder of the efficient market hypothesis. In his theory, all irrational trading on markets are seen as an opportunity for arbitrage, so smart traders will exploit these opportunities and therefore bring market prices back (or up) to its intrinsic value. He also argues that it is impossible to systematically beat the market, because all public information will be priced in immediatly after they get published. Therefore, future changes in the prices are subject to a random walk.
Shiller on the other hand says that markets can systematically make mistakes. This happens because of two factors:
First, human beings are not rational. They make mistakes, consiously or not. There are some simple examples like the gambler's fallacy or overconfidence. But there are also some more comples heuristics and biases that people tend to implement into their decisions. These psychological factors are subject to the field of study called "behavioral finance".
Second, while Fama argued that arbitrageurs will bring back market prices to fundamentals, Shiller says that there are limits to arbitrage, where it is the rational incentive for arbitrageurs to not exploit over-or underpriced assets. These can be certain risks or costs.
In my opinion, Fama's theory is a good way to explain the basic information processing function of financial markets while shiller's focus is better to describe market anomalies.
What are your thoughts on these two ?
Cheers,
Marone
Efficient Market Hypothesis is incomplete and insufficient. I agree much more with Shiller-type theories, and think behavioural finance/irrationality plays a HUGE (and most likely understated) role in market movements.
There are a bunch of factors that affect price, that have nothing to do directly with information embedded in securities. For example, fixed income funds that can only hold investment grade securities- if a bond is downgraded, some funds that hold it will have to sell it. This has a basis in behavioural finance and is not necessarily rational- rationally, the investment may still be sound in spite of a downgrade. Etc etc.
That being said, I think Fama-type theories (EMH) loosely encapsulate what happens in markets and are a pretty good proxy for how securities react to new information.
I heard your exact post on a talk show today lol.
Mine or OP's? I'll have to listen to it if it was mine- where can I find it, would you know?
OP. But fyi, a lot of what i listen to is NPR. They have some pretty good stuff, specifically their analyses commentary which covers a breadth of stuff.
So, in order to determine the validity of the EMH, we merely need to look at the implications of the theory and see how well it holds up to empirical results.
Implications of EMH:
(1) Active management and excessive trading is bad. You want to put your money into a broadly diversified portfolio and just sit on it in order to minimize transaction costs. This will lead to highest overall return. (2) Institutions that try to generate alpha, such as hedge funds, will not stay in business for any extended period of time insofar as they don't have access to insider information (this doesn't hold for the strong version, but most people don't refer to the strong version when they're talking about the EMH). In other words, active hedge fund managers should have a high turnover. (3) Prices movements should appear random.
All 3 implications are supported by the empirical evidence. Implication 1, oddly enough, is actually implicitly assumed by Shiller himself when he talks about the irrationality of the retail investor and the relative inefficiency of active trading. Active trading could work in an inefficient market. The evidence also states that generating alpha almost always requires large economies of scale--a condition that wouldn't be required in an inefficient market. No need to mention the relative performance of the hedge fund industry in general.
There are some empirical results that seem to contradict the EMH. First, it seems that momentum trading, following analyst expectations, and reactions to earnings reports violate the various versions of the theorem. The empirical evidence for the first two is not too clear once you include transaction costs. The third situation, where reactions to earnings reports appear to be lagged, is somewhat puzzling.
My conclusions:
(1) The evidence in general tends to support the EMH. People who shit on the theory generally don't understand it and/or confuse it with normative, political positions. They do stupid things like try to justify government intervention by attacking the relative 'inefficiency' of markets (especially in times of extreme volatility, which doesn't contradict the EMH in anyway whatsoever). (2) Fama obviously deserves the prize. Everyone knew that he would get it at some point. It's too bad that the Swedish bank felt the need to throw Shiller in there, which was an obvious political move (they hate being called a 'right-wing' institution).
I take pleasure in knowing that (a) you can't substantively respond to my comment and (b) it won't let you throw shit at me. Here's one for you though.
cheers
The way I was taught made me feel that Fama's EMH was more like a general guide to how to look at the market, whereas Shiller was more of a micro perspective.
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