[lbo-talk] "Bedlamite economics" and the EMH

Ted Winslow egwinslow at rogers.com
Thu Nov 12 09:09:00 PST 2009


In the interview quoted by Krugman, Eugene Fama claims that the problems in financial markets don't falsify the EMH, i.e. don't falsify the assumption that financial market participants can and do form rational expectations of future phenomena relevant to present valuations so that present prices always embody this knowledge; the problems derive from the fact that this assumption is false:

“The premise of the Fox book [“The Myth of the Rational Market”] is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH), which posits that market prices reflect all available information. The claim is that the world's investors and their advisors in the financial industry bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. The most recent is the rise and sharp decline in real estate prices which froze financial markets and led to the worst recession since the Great Depression of the 1930s.

“The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don't believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finally, MBA students who aspire to high paying positions in the financial industry have a tough time finding a job if they accept the EMH.

“I continue to believe the EMH is a solid view of the world for almost all practical purposes. But it's pretty clear I'm in the minority. If the EMH took over the investment world, I missed it.” http://www.dimensional.com/famafrench/2009/11/qa-is-market-efficiency-the-culprit.html

Ted



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