I’m going to defend the poor old efficient markets hypothesis. Somebody has to. It’s been getting quite a pounding since the credit crunch began. David Wighton of The Times commented in January 2009, “The theory was officially declared dead at the World Economic Forum in Davos. There were no mourners.” In June of that year, Roger Lowenstein wrote in The Washington Post, “The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis.” More recently, Matthew Bishop and Michael Green, authors of The Road from Ruin, have argued that the EMH was partly responsible for the crisis.
It’s probably worth pausing for a moment to recall what the EMH actually means. It’s not a Reaganite claim about the superiority of free markets over government intervention; it’s a far narrower and more technical claim about the price of liquid assets such as shares or corporate bonds. It is, nevertheless, hugely important.
The EMH has several forms. The weakest says that not only is past performance no guarantee of future performance, but nothing about the way a share’s price has bounced around in the past tells you anything about how it will move in the future. The strongest says that the market price is the correct price: that all privately and publicly available information that might be relevant to the value of a share is already reflected in today’s price. The weak form tells you not to listen to stock pickers who point to recently soaring shares. The strong form tells you not to bother doing any research into shares, because it cannot possibly do you any good.
In its strong form, the EMH cannot always be true. (How would the market become so efficient, since no rational participants would bother with research?) Perhaps it is never true, although as my colleague John Kay has pointed out, the difference between the EMH usually being true and always being true may be difference enough to explain the likes of Warren Buffett.
But did the EMH lead to the crisis? Not directly, for sure. The first thing the EMH would tell you is to be suspicious of bond salesmen who claim that structured subprime vehicles can offer high rewards and almost no risk. I think it is telling that according to Michael Lewis’s book The Big Short, some savvy investors who wanted to bet against subprime mortgages hesitated to do so, for fear that they had missed a trick. They instinctively took the EMH seriously, and only bet heavily against subprime after they had met the subprime enthusiasts and concluded they really were as foolish in person as their strategies suggested. The EMH encourages scepticism, not gullibility, about sure-thing investments.
It is more defensible to suggest that the EMH worked wickedness indirectly, through the attitude of regulators. Matthew Bishop tells me that he sees three ways in which the EMH was responsible for the crisis. First, it seduced Alan Greenspan into believing either that bubbles never happened, or that if they did there was no hope that the Federal Reserve could spot them and intervene. Second, the EMH motivated “mark-to-market” accounting rules, which put banks in an impossible situation when prices for their assets evaporated. Third, the EMH encouraged the view that executives could not manipulate the share prices of their companies, so it was perfectly reasonable to use stock options for executive pay. These are cogent points. Regulators, then, should be wary of the EMH.
Yet I remain convinced that the efficient markets hypothesis should be a lodestar for ordinary investors. It suggests the following strategy: choose a range of shares or low-cost index trackers and invest in them gradually without trying to be too clever. If only a few more bankers had taken such advice seriously.
Also published at ft.com.