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Efficient Market Hypothesis Wins 2013 Nobel Economic Prize


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Guest hellsten

This is funny:

Peter Englund, professor of banking at the Stockholm School of economics and member of the prize committee, said their research had deeply influenced modern finance.

 

"The most obvious application, that follows on from Fama's research, is the insight that you can't beat the market. It is impossible to prove that equity analysis is worth the money," he told Reuters.

 

"That has led to the development of index funds and that most households actually put their savings in index funds."

 

http://www.reuters.com/article/2013/10/14/us-nobel-economics-idUSBRE99D07F20131014

 

The professor probably thinks there's no such thing as a housing bubble ;D What bubble, where?

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I don't think Fama and Shiller quite agree with each other on the "strength" of the EMH.  Fama is a true Chicago academic - he's on record saying that no analyst could have predicted the housing crash, banking crisis, etc.  Even though many did. 

 

Shiller is on the other side of the fence and has used the term bubble on numerous occasions to explain asset prices.

 

But both believe that the investing public should invest in index funds and not try to beat the market.  This is also Buffett's opinion as well.  This was their reason for the Nobel Prize.

 

The Nobel Prize is less of a "your research was progressive and changed economics for the better" award.  It's more of a "Lifetime Achievement Award" for economics at this point.

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Do you have Fama's link where he says "nobody predicted the crash"?

 

My understanding of Fama's view is - The market as an aggregate could not predict the crash, but when it did detect the incoming recession, it declined.

 

hellsten - Fama has also been on record saying that there is no definition of a "bubble", and they're only named in hindsight.

 

I believe that this prize is well deserved for Mr Fama. While the EMH does not hold up in every circumstance, especially where its assumptions break down - I agree with John Cochrane that it is much closer to being right than wrong.

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Do you have Fama's link where he says "nobody predicted the crash"?

 

My understanding of Fama's view is - The market as an aggregate could not predict the crash, but when it did detect the incoming recession, it declined.

 

hellsten - Fama has also been on record saying that there is no definition of a "bubble", and they're only named in hindsight.

 

I believe that this prize is well deserved for Mr Fama. While the EMH does not hold up in every circumstance, especially where its assumptions break down - I agree with John Cochrane that it is much closer to being right than wrong.

 

This came up in an EconTalk podcast with Fama, I've copied the response below, Fama is "Guest"

 

Russ: I was going to ask you about the current crisis. Guest: I have some unusual views on that, too. Russ: I'd say that the mainstream view--and I recently saw a survey that said--it was an esteemed panel of economists; you weren't on it but it was still esteemed, both in finance and out of finance. And they asked them whether prices reflected information and there was near unanimity. Some strongly agreed; some just agreed. But there was also near unanimity that the housing market had been a bubble. Guest: The nasty b-word. Russ: Yes; and was showing some form of what we might call irrationality. Guest: Okay, so they had strong feelings about that, getting mad about the word bubble. Russ: Why? Guest: Because I think people see bubbles with 20-20 hindsight. The term has lost its meaning. It used to mean something that had a more or less predictable ending. Now people use it to mean a big swing in prices, that after the fact is wrong. But all prices changes after the fact are wrong. Because new information comes out that makes what people thought two minutes ago wrong two minutes later. Housing bubble--if you think there was a housing bubble, there might have been; if you had predicted it, that would be fine; but the reality is, all markets did the same thing at the same time. So you have to really face that fact that if you think it was a housing bubble, it was a stock price bubble, it was a corporate bond bubble, it was a commodities bubble. Are economists really willing to live with a world where there are bubbles in everything at the same time? Russ: And your explanation then of that phenomenon? Guest: My explanation is you had a big recession. I think you can explain almost everything just by saying you had a big recession. A really big recession. Russ: And why do you think we had a really big recession?

 

The full transcript: http://www.econtalk.org/archives/2012/01/fama_on_finance.html

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Guest hellsten

 

 

Thanks. This is very interesting:

Guest: My explanation is you had a big recession. I think you can explain almost everything just by saying you had a big recession. A really big recession.  Russ: And why do you think we had a really big recession? Guest: I've heard some of your podcasts; I'm with you. I don't think macroeconomists have ever been good at knowing why we have recessions. We still don't understand the Great Depression.

 

 

Guest: Finance has developed quite a lot in the last 50 years that I've been in it. I would say the people who do asset pricing--portfolio theory, risk and return--those people think markets are pretty efficient. If you go to people in other areas who are not so familiar with the evidence in asset pricing, well, then there is more skepticism. I attribute that to the fact that finance, like other areas of economics, have become more specialized. And people just can't know all the stuff that's available. Russ: Sure. Guest: There's an incredible demand for market inefficiency. The whole investment management business is based on the idea that the market is not efficient. I say to my students when they take my course: If you really believe what I say and go out and recruit and tell people you think markets are efficient, you'll never get a job.

 

 

Russ: Some great ones. Guest: They beat their benchmarks by 3-6% a year. Nevertheless, only 3% of them do about as well as you would expect by chance. Now what's subtle there is that by chance, with 3000-plus funds, you expect lots of them to do extremely well over their whole lifetime. So, these are the people that books get written about. Russ: Because they look smart. Guest: What this basically says is that there is a pretty good chance they are just lucky. And they had sustained periods of luck--which you expect in a big sample of funds. Russ: Of course, they don't see it that way. Guest: No, of course not.

 

Sounds like he's saying people don't know what they are talking about:

I attribute that to the fact that finance, like other areas of economics, have become more specialized. And people just can't know all the stuff that's available.
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Are economists really willing to live with a world where there are bubbles in everything at the same time?

...

My explanation is you had a big recession. I think you can explain almost everything just by saying you had a big recession.

 

There are appealing parts to EMH, but this part seems pretty lousy. It's not even wrong in a clever way, it's wrong in a dumb and naive way.

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Markets are fairly efficient. I think there is that rare talent that can beat it over the long term. Including a lot of folks on this board. However, the vast majority fail to beat it. Discount luck and the results are even worse.

 

Look at Nygren at Oakmark Select. After taxes, he's underperformed the S&P 500. Or, look at Bill Miller at Legg Mason Value Trust. Beat it nearly over 30 years and then a few horrible years ruined his great track record. These guys are top fund managers. Heck, look at Sequoia. The crown jewel of mutual funds and it's beaten the S&P 500 only by about 1.5% per annum before taxes.

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Markets are fairly efficient and most reasonable people would agree with that. But Fama goes much further. He practically denies there is such a thing as a bubble. Any time there is a factor that is identified that has shown historical outperformance, he turns it into a risk factor. Small stocks have higher returns, well small stocks are more risky, value has higher returns, value must be more risky and so on. According to him, the highest priced stocks (or as her prefers low Book to Price) have low risk. As Taleb like to say, he is a perfect example of an "equation solver" with Physics Envy.

 

Shiller on the other hand, is much much more reasonable and humble guy and fully deserves the prize.

 

Here is an interview with Fama:

 

http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=1134

 

    Well, economists are arrogant people. And because they can’t explain something, it becomes irrational. The way I look at it, there were two crashes in the last century. One turned out to be too small. The ’29 crash was too small; the market went down subsequently. The ’87 crash turned out to be too big; the market went up afterwards. So you have two cases: One was an underreaction; the other was an overreaction. That’s exactly what you’d expect if the market’s efficient.

 

    The word “bubble” drives me nuts. For example, people say “the Internet bubble.” Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful.

    I did a calculation. Microsoft was an example of a corporation that came from the previous revolution, the computer revolution. It was hugely profitable and successful. How many Microsofts would it have taken to justify the whole set of Internet valuations? I think I estimated it to be something like 1.4.

 

 

Vinod

 

 

 

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Ah, but which Buffett is beating the indexes? The one running the public company or the one running the bpl fund? The one running the fund looked for nooks of value and special situations which in a sense is looking for instances where meh breaks down. The one running the public company is a very different situation - meh doesn't state that public firms cannot outperform indexes.

 

I do not believe EMH is 100 pct true, but I think it far closer to true than false and the main conclusion IMO - that hiring a skilled and experienced mgr may not perform better than you is pretty striking in my opinion.

 

Same way I'm sure you could perform as well as an NFL GM in building your draft.

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Markets are fairly efficient and most reasonable people would agree with that. But Fama goes much further. He practically denies there is such a thing as a bubble. Any time there is a factor that is identified that has shown historical outperformance, he turns it into a risk factor. Small stocks have higher returns, well small stocks are more risky, value has higher returns, value must be more risky and so on. According to him, the highest priced stocks (or as her prefers low Book to Price) have low risk. As Taleb like to say, he is a perfect example of an "equation solver" with Physics Envy.

 

Shiller on the other hand, is much much more reasonable and humble guy and fully deserves the prize.

 

Here is an interview with Fama:

 

http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=1134

 

    Well, economists are arrogant people. And because they can’t explain something, it becomes irrational. The way I look at it, there were two crashes in the last century. One turned out to be too small. The ’29 crash was too small; the market went down subsequently. The ’87 crash turned out to be too big; the market went up afterwards. So you have two cases: One was an underreaction; the other was an overreaction. That’s exactly what you’d expect if the market’s efficient.

 

    The word “bubble” drives me nuts. For example, people say “the Internet bubble.” Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful.

    I did a calculation. Microsoft was an example of a corporation that came from the previous revolution, the computer revolution. It was hugely profitable and successful. How many Microsofts would it have taken to justify the whole set of Internet valuations? I think I estimated it to be something like 1.4.

 

 

Vinod

The problem is inherent in the EMH framework itself. The framework is logically unflawed, but rests upon axioms which may or may not be true. Irrational bubbles and pricing anomalies cannot exist since the few people who see them coming may have been just lucky, while if the bubbles were identified by lots of people they would never have been blown up to that extent. Because the nature of bubbles is that they can only be widely identified post hoc, it's a meaningless concept.

 

Well, maybe. But I find that some people who share roughly the same framework consistently either do not partake in these bubbles or actively bet against them. Hard to show statistically, I guess.

 

Btw, I read somewhere that Fama stated that Shiller had been speaking about a real estate bubble since 1996, which was news to me. Would be interesting to find the quotes from that time.

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