The Efficient Market Hypothesis and Its Critics
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Journalof Economic Perspectives—Volume 17,Number 1—Winter 2003— Pages 59 – 82 TheEf cient Market Hypothesisand Its Critics BurtonG. Malkiel generationago, theef cient market hypothesis was widelyaccepted by academic nancial economists; forexample, see Eugene Fama’ s (1970) A inuential survey article, “ Efcient Capital Markets.” It was generallybe- lievedthat securitiesmarkets were extremely ef cient in re ecting information about individualstocks and about thestock marketas awhole.The accepted view was that when informationarises, the news spreads veryquickly and isincorporated intothe prices of securitieswithout delay. Thus, neithertechnical analysis, which is thestudy ofpast stock pricesin an attemptto predict future prices, nor even fundamental analysis, which isthe analysis of nancial informationsuch as com- pany earningsand asset valuesto help investors select “ undervalued”stocks, would enablean investorto achieve returns greater than those that could beobtained by holdinga randomlyselected portfolio of individual stocks, at leastnot withcom- parablerisk. Theef cient market hypothesis isassociated withthe idea of a“random walk,” which isatermloosely used inthe nance literatureto characterizea priceseries whereall subsequent pricechanges representrandom departuresfrom previous prices.The logic of the random walkidea is that ifthe owof information is unimpededand informationis immediately re ected in stock prices,then tomor- row’s pricechange willre ect only tomorrow’ s newsand willbe independent of the pricechanges today. Butnews is by de nition unpredictable, and, thus, resulting pricechanges must beunpredictable and random. Asaresult,prices fully re ect all known information,and evenuninformed investors buying a diversied portfolio at thetableau of prices given by the market will obtain arateof return as generousas that achievedby the experts. y BurtonG. Malkielis Chemical Bank Chairman’ s Professorof Economics, Princeton University,Princeton, New Jersey.His e-mail addressis [email protected] . 60Journal of Economic Perspectives Theway I put itinmybook, ARandomWalk Down Wall Street , rstpublished in 1973,a blindfoldedchimpanzee throwing darts at the WallStreet Journal could select aportfoliothat woulddo as wellas theexperts. Of course, theadvice was not literallyto throw darts, but instead tothrow a towelover the stock pages —that is, tobuy abroad-based indexfund that bought and heldall the stocks inthemarket and that chargedvery low expenses. Bythe start of the twenty- rstcentury, the intellectual dominance ofthe ef cientmarket hypothesis had becomefar less universal. Many nancial econo- mistsand statisticians began tobelieve that stock pricesare at leastpartially predictable.A newbreed of economistsemphasized psychological and behavioral elementsof stock-price determination, and theycame to believe that futurestock pricesare somewhat predictable on thebasis ofpast stock pricepatterns as wellas certain “fundamental ” valuation metrics.Moreover, many ofthese economists were evenmaking the far more controversial claim that thesepredictable patterns enableinvestors to earn excess risk adjusted ratesof return. This paperexamines the attacks on theef cientmarket hypothesis and the beliefthat stock pricesare partially predictable. While I makeno attemptto present acompletesurvey of the purported regularities or anomalies in thestock market, Iwilldescribe the major statistical ndings as wellas theirbehavioral underpin- nings, whererelevant, and also examinethe relationship between predictability and ef ciency.I willalso describethe major argumentsof those who believethat marketsare often irrational by analyzingthe “crash of1987, ” theInternet “bubble” of the n de siecle and otherspeci cirrationalitiesoften mentioned by critics of ef ciency.I conclude that ourstock marketsare far more ef cientand farless predictablethan somerecent academic papers wouldhave us believe.Moreover, theevidence is overwhelming that whateveranomalous behaviorof stock prices mayexist, it does not createa portfoliotrading opportunity that enablesinvestors toearn extraordinary risk adjusted returns. Atthe outset, itis important to make clear what Imeanby the term “ef - ciency.” Iwilluse as ade nition of ef cient nancial marketsthat such marketsdo not allowinvestors to earn above-average returns without accepting above-average risks.A well-knownstory tells of a nance professorand astudent who comeacross a$100bill lying on theground. As thestudent stops topickit up, theprofessor says, “Don’t bother—ifit were really a $100bill, it wouldn ’t be there.” Thestory well illustrateswhat nancial economistsusually mean when theysay marketsare ef cient.Markets can beef cientin this senseeven if theysometimes make errors invaluation, as was certainlytrue during the 1999 – early2000 Internet “bubble.” Marketscan beef cienteven if many marketparticipants arequite irrational. Marketscan beef cienteven if stock pricesexhibit greater volatility than can apparentlybe explained by fundamentals such as earningsand dividends. Many of us economistswho believein ef ciencydo so because weviewmarkets as amazingly successful devicesfor re ectingnew information rapidly and, forthe most part, accurately.Above all, we believe that nancial marketsare ef cientbecause they don’tallowinvestors to earn above-average risk adjusted returns.In short, we BurtonG. Malkiel 61 believethat $100bills are not lyingaround forthe taking, either by the professional orthe amateur investor. What Ido not argueis that themarket pricing is always perfect.After the fact, weknowthat marketshave madeegregious mistakes, as Ithinkoccurred during the recentInternet “bubble.” Nordo Idenythat psychologicalfactors in uence securitiesprices. But I am convinced that Benjamin Graham (1965)was correctin suggestingthat whilethe stock marketin the short run maybe a votingmechanism, inthe long run itis a weighingmechanism. Truevalue will win out inthe end. Beforethe fact, thereis no wayin which investorscan reliablyexploit any anomalies orpatterns that mightexist. I am skepticalthat any ofthe “predictablepatterns ” that have beendocumented in theliterature were ever suf cientlyrobust so as to have createdpro tableinvestment opportunities, and afterthey have beendiscov- eredand publicized,they will certainly not allowinvestors to earn excess returns. ANonrandom Walk Down Wall Street In this section, Ireviewsome of the patterns ofpossible predictability sug- gestedby studies of the behavior of past stock prices. Short-TermMomentum, Including Underreaction to New Information Theoriginal empirical work supporting thenotion ofrandomness instock priceslooked at measuresof short-run serialcorrelations between successive stock pricechanges. In general,this worksupported theview that thestock markethas no memory—that is, theway a stock pricebehaved in the past isnot usefulin divininghow itwill behave in the future; for example, see the survey of articles contained inCootner (1964). More recent work by Lo and MacKinlay(1999) nds that short-run serialcorrelations are not zeroand that theexistence of “too many” successivemoves in the same direction enable them to reject the hypothesis that stock pricesbehave as truerandom walks.There does seemto be some momentum inshort-run stock prices.Moreover, Lo, Mamaysky and Wang (2000)also nd, through theuse ofsophisticated nonparametricstatistical techniques that can recognizepatterns, someof the stock pricesignals used by “technicalanalysts, ” such as “head and shoulders ” formationsand “doublebottoms, ” mayactually have some modestpredictive power. Economistsand psychologists inthe eldof behavioral nance nd such short-run momentumto be consistent withpsychological feedback mechanisms. Individuals seea stock pricerising and aredrawn intothe market in a kindof “bandwagon effect. ” Forexample, Shiller (2000) describes the rise in the U.S. stock marketduring the late 1990s as theresult of psychological contagion leadingto irrationalexuberance. The behavioralists offered another explanationfor patterns ofshort-run momentum —atendencyfor investors to underreact to new informa- tion. If thefull impact of an importantnews announcement isonlygrasped over a periodof time, stock priceswill exhibit the positive serial correlation found by 62Journal of Economic Perspectives investigators.As behavioral nance becamemore prominent as abranch ofthe study of nancial markets,momentum, as opposed torandomness, seemedrea- sonable tomany investigators. However,several factors should preventus frominterpreting the empirical resultsreported above as an indication that marketsare inef cient.First, while the stock marketmay not bea mathematicallyperfect random walk,it is importantto distinguishstatistical signi cance fromeconomic signi cance. Thestatistical de- pendenciesgiving rise to momentum are extremely small and arenot likelyto permitinvestors to realize excess returns. Anyone who pays transactions costs is unlikelyto fashion atradingstrategy based on thekinds ofmomentum found in thesestudies that willbeat a buy-and-hold strategy.Indeed, Odean (1999)suggests that momentuminvestors do not realizeexcess returns. Quite the opposite —a sampleof such investorssuggests that such tradersdid farworse than buy-and-hold investorseven during a periodwhere there was clearstatistical evidence of positive momentum.This isbecause ofthe large transactions costs involvedin attempting toexploit whatever momentum exists. Similarly, Lesmond, Schilland Zhou (2001) nd that standard “relativestrength