Efficient markets theory

Efficient markets theory, as formulated by Fama (1970, 1991), rejects the existence of unexploited profit opportunities in financial markets, arguing that the actions of profit-seeking traders will cause asset prices to reflect all available information. Acceptance of efficient markets theory implies nothing about whether financial markets coordinate investment and saving decisions in an orderly, socially optimal or stable manner, but only about whether it is possible for an investor to systematically "beat the market" (Tobin, 1984).

The weak form of efficient markets theory holds that knowing past asset prices will not enable an investor to follow a profitable trading rule. The semi-strong form holds that no publicly available information will enable an investor to beat the market, because all public information will have been already taken into account.

According to the strong form of efficient markets theory, even privately held "inside information" is fully reflected in asset prices as a result of attempts by insiders to act on the private information they possess. Even strong critics of efficient markets theory as a basis for understanding the financial system often accept the weak form, while even vehe- ment defenders of the general spirit of efficient markets theory usually concede that the strong form of the theory goes too far (see Malkiel, 2003; Shiller, 2003).

Louis Bachelier, in his 1900 Paris doctoral dissertation in mathematics on the theory of speculation (translated in Cootner, 1964), argued that, if investors use all available information and take all profit opportunities, asset prices will follow a random walk in discrete time, with the current price being the best forecast of future price (Dimand and Ben-El-Mechaiekh, 2006; Weatherall, 2013). Bachelier posited that asset price changes are normally distributed, but, as Benoît Mandelbrot was the first to notice, Bachelier concluded as early as 1914 that the tails of distributions of asset price movements were too fat for the distributions to be normal.

In later versions of efficient markets theory, the assumption of a random walk was replaced by the slightly weaker assumption that asset price changes follow a martingale, which does not require successive movements to be probabilistically independent of each other, but retains the property that the current price is the best forecast of the next peri- od's price (LeRoy, 1989). In the wake of the stock market crash of 1929, Cowles (1933) presented evidence that stock market forecasters failed to predict stock price movements, which are random - although he later accepted that at least one forecasting service had consistently done better than could be explained by chance (Dimand, 2009). Following Bachelier and Cowles, later efficient markets theorists held that investors are rational when pricing assets (so that asset prices fluctuate randomly, without serial correlation between changes) and irrational when paying for stock market forecasts (predictions of the unpredictable), so that investors would be best off to just invest through index funds and avoid the costs of active management of portfolios (Cootner, 1964; Fama 1970, 1991).

Critics of efficient markets theory present evidence of serial correlation in asset price movements, indicating the possibility of bubbles and of predictable price movements (Lo and MacKinlay, 1999). Behavioural finance, which views the actions of investors as guided by conventions, rules of thumb and heuristic biases, has emerged as an alterna- tive to the rationality assumed in efficient markets theory (Shleifer 2000; Shiller, 2000, 2003). From the 1960s onward, Mandelbrot has emphasized fat-tailed distributions of asset price movements, with much greater likelihood of large movements than would be consistent with normal (Gaussian distributions), and even with infinite variance (see Mandelbrot and Hudson, 2004). Shiller (2000) finds that asset prices fluctuate much more than can be explained by changes in underlying fundamentals. Drawing on the distinction made by John Maynard Keynes and Frank Knight between insurable risk and uninsurable uncertainty, Davidson (1991) views the underlying stochastic processes as non-ergodic; that is, as subject to unpredictable structural breaks. Taleb (2010) uses the term "black swan" for events not even considered among the possibilities when expecta- tions were formed.

Fat tails, excess volatility, fundamental uncertainty and non-ergodicity, and black swans are all ways of expressing the basic insight that knowledge of the future is limited, and mathematical models of rational choice in efficient markets cannot tame uncertainty, or reduce it to insurable risk with a known, tractable probability distribution - which, ironically, marks a return to the original argument of Bachelier and Cowles that it is impossible to predict how asset prices will change, and to efficient markets arguments that an investor cannot make predictions that will beat the market just by knowing past asset prices.

In October 2013, Eugene Fama, who stated and named the efficient markets hypoth- esis, and Robert Shiller, its leading critic, shared the "Royal Bank of Sweden Prize in Economic Science in Memory of Alfred Nobel" with Lars Peter Hansen, who developed a statistical technique for evaluating such theories about asset price movements.

See also:

Asset price inflation; Bubble; Credit bubble; Financial crisis.