Markets Are Mostly Efficient

by: Lars Christensen

I just stumbled on this interesting discussion between Eugene Fama and Richard Thaler - they talked about whether markets are efficient or not.

Thaler argues that markets are not efficient. Fama agrees, but nonetheless argues that we have no better model of the world. It shouldn't be a surprise to my readers that I agree more with Fama than with Thaler.

What I particularly notice is just how little evidence Thaler is able to present that markets are not efficient. Yes, he comes up with anecdotes, but that is not evidence. With billions of investors and billions of different markets and prices, you will always be able to come up with some example of pricing behavior, which in some way looks inefficient or irrational, but that does not mean that you generally can say markets are inefficient rather than efficient.

My own view is very much based on my experience from working more than 15 years in financial markets. So even though I theoretically always have had a lot of sympathy of Eugene Fama's thinking about financial markets, it is not really the theoretical arguments that convince me these days.

It is simply my experience that I never meet anybody in the financial markets who consistently have been able to beat the markets. I meet a lot of people who think they can beat the market, but that is not the same as they are right (they are not).

Obviously, with billions of people around the world making decision and investments, some will for periods do better than others, but this is essentially down to luck (or inside information!).

One thing that particularly has convinced me that markets are mostly efficient is my empirical work on exchange rates. The models I have built over the years have shown me that the more information about the world I get into the model, the better the models are. The interesting thing has been that the more information I have incorporated into the empirical models, the closer the "forecast" from these models have come to market expectations of future exchange rates. Furthermore, my experience with the typical bank analysts' forecasts of exchange rates, I have learned that they rarely outperform market expectations.

This has shown me that most available information mostly is also reflected in the exchange rate, and as a consequence, I have had to come to the conclusion that I probably not will be able to beat the markets. And try to think about it - with billions of people trying to forecast the future exchange rates, why would I be able to do better than the average forecast? What information do I have that they don't? The Efficient Market Hypothesis (EMH) essentially is about being humble about your own abilities.

What do both Fama and Thaler miss? I notice that both of them completely miss the importance of changes in policy - particularly in monetary policy. Simple forward-looking behavior of, for example, the stock markets or FX markets will show that even fairly small changes in the expected future growth rate of consumer prices or nominal incomes can have very large impact on, for example, the spot exchange rate if prices are rigid.

An example of this is Dornbusch's famous overshooting model for exchange rate determination. In Dornbusch's model, there can be large fluctuations in the exchange rate, but it does not reflect inefficient markets or irrational behavior, but completely rational forward-looking behavior.

Believing that markets are mostly efficient is not assuming some kind of superhuman abilities. It is simply a matter of acknowledging the fact that billions of peoples' knowledge is very well reflected by the price system. There is no better mechanism for aggregating information and there exists no better mechanism for aggregating information than the price mechanism.

As Eugene Fama stresses - the Efficient Market Hypothesis - is a theory and as such is not 100% correct as it is exactly a theory, but so far no economist has come up with any theory that describes the world better than EMH, and I see very little reason to think that that will change anytime soon.

Update: Apparently, somebody is able to beat the market in a dramatic fashion. Just see the impressive trading performance of US Democrat Congresswoman Judy Chu. I am not making any judgements here, other than noting that she is a politician and not a regular trader. Another Democrat also once had a fantastic trading record.