What Theory Wrought

The Moment of Reckoning

The Financial Crisis of 2008, like many of the financial crises that preceded it over the last 30 years, was a moment of reckoning for financial economists and professionals. While Wall Street titans and former world-saviors like Alan Greenspan paraded in front of the US Congress to discuss various their personal involvement in this global catastrophe, the rest of the community was left to ponder a simple, but unrelenting, question: “How did we let this happen?”

For many, this kind of thing was never supposed to happen; in economist terms, it was theoretically impossible, a ten-sigma kind of event. Stories abound about young financial analysts who presented models that these kinds of events could only happen once in 10,000 years,[1] seemingly unaware of the similarly unexpected collapse of Long Term Capital Management barely a decade ago. Others were devastated as they watched carefully priced financial portfolios evaporate into thin air. The market is rational and efficient, they would say. The prices of various financial products corresponded perfectly to the aggregate sum of the information available. As more than 4 trillion dollars of wealth was lost, it became quickly clear that something was fundamentally wrong.[2]

The suffering was of this global financial meltdown shared by many, and few were exempt from this collective intellectual and professional failure. Yet there were exceptions, and they were definitely notable. Nicolas Nassim Taleb, famous for his “Black Swan” proclamations of market calamity, watched hedge funds based on his theory increased in value nearly seven times over.[3] John Paulson, manager of the Paulson and Co. hedge fund, made 15 billion dollars in a single trade that bet against the housing market.[4] And Dick Thaler, a Professor at the Booth School of Business at the University of Chicago, saw his branch of Behavioral Economics grow into one of the most influential theories in finance today.

Following Justin Fox’s book The Myth of Rational Markets,[5] this paper will present a portion of the intellectual history that led up to this historic event. While partially reductive, it splits financial theorists into two basic camps: those who describe the market as fundamentally efficient and those who focus on its irrationality. Although not nearly as comprehensive as Fox’s book, an impossible task considering the length of this essay, the following pages will describe the general rise of Effecient Market Theory (EMT), especially the version championed by Eugene Fama, to becoming one of the basic pillars of modern finance. At the same time, it will look at a few of the stories of those professionals and theorists who vocally criticized EMT and how recent events have vindicated their work.

While I won’t be able to settle the behavioral vs. rational debate, I will provide perspective on how this debate continues to influence the practice of finance today. Most importantly, I hope to show how neither theory can provide of perfectly accurate description of the market, and how both theories support the assumptions of the other.

What We Once Knew

For most of its history, the study of economics concerned the nature of man as much as the nature of business and transactions. Adam Smith, the founder of modern economic thought, did not originally develop his famous “invisible hand” in the book usually credited for creating the study of economics – The Wealth of Nations. In fact, the theory was developed earlier, in his Theory of Moral Sentiments, a comprehensive psychological analysis of man. This concept is elaborated during a section on utility, which Smith recognizes as an inconsistent quality that is not always properly appreciated by society. As he explains,

But that this fitness, this happy contrivance of any production of art, should often be more valued, than the very end for which it was intended; and that the exact adjustment of the means for attaining any conveniency or pleasure, should frequently be more regarded, than that very conveniency or pleasure, in the attainment of which their whole merit would seem to consist, has not, so far as I know, been yet taken notice of by any body. That this however is very frequently the case, may be observed in a thousand instances, both in the most frivolous and in the most important concerns of human life.[6]

This is just one of many examples from Smith that demonstrate his lack of faith in the underlying rationality of man. Throughout the chapter, he constantly rails against man’s “frivolity,” repeatedly pointing out how utility is ignored in favor of fashion or a sense of proper order. The master that orders a room cleared is going against his basic need to use the furniture in the room; the owner of a watch does not improve his own punctuality if he trades his current watch in for one that is more expensive.

In fact, this underlying lack of rationality drives many to ruin. Smith goes so far as to blame tailors for creating extra pockets for no other need that to stuff more useless junk in them. He writes with a certain sense of despair about his contemporaries’ habit of walking “about loaded with a multitude of baubles, in weight and sometimes in value not inferior to an ordinary Jew's-box, some of which may sometimes be of some little use, but all of which might at all times be very well spared, and of which the whole utility is certainly not worth the fatigue of bearing the burden."[7]

Yet, this fundamental “frivolity” comes to benefit mankind as a whole. As Smith explains,

And it is well that nature imposes upon us in this manner. It is this deception which rouses and keeps in continual motion the industry of mankind. It is this which first prompted them to cultivate the ground, to build houses, to found cities and commonwealths, and to invent and improve all the sciences and arts, which ennoble and embellish human life; which have entirely changed the whole face of the globe, have turned the rude forests of nature into agreeable and fertile plains, and made the trackless and barren ocean a new fund of subsistence, and the great high road of communication to the different nations of the earth.

In other words, while we may be obsessed with useless nonsense, trinkets and trash, our obsession with attaining these things have caused mankind to do remarkable things. Our desire to consume, while not rational, creates cities, fields and roads, in essence the fundamental elements of society itself.

This turn of logic leads Smith to his explanation of the invisible hand,

The rich only select from the heap what is most precious and agreeable. They consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.[8]

Already, we have the elements of the fundamental debate within economics. People are inherently irrational, and their behavior is largely selfish and directed to fulfilling unnecessary desires. Yet, in the aggregate, this kind of behavior has led society to flourish. Frivolity inspires the creation of the useful things, and more importantly, irrational behavior still leads to an efficient distribution of resources among all members of society. While creating economics, Smith has already created its greatest debate. Are markets, the result of irrational men, rational as well?

The Market Can’t be Beaten

Neoclassical economics solves the dichotomy existing between man’s self-interest and the societal greater good by simply removing Adam Smith’s concept of “frivolity,” man’s basic lack of rationality. This “bleaching” of man’s psychological dispositions allowed for a new level of sophistication in economic modeling and economic mathematics.[9] Paul Samuelson’s Foundations of Economic Analysis set the standard for this kind of work, demonstrating “that a comparatively small number of mathematical propositions contain the formal (or logical) basis of much of economic theory.”[10]

Others dealt with this issue by denigrating each individual’s role in the final total outcome. John Maynard Keynes was particularly harsh in this critique. As he explains in The General Theory of Employment, Interest, and Money,

Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.[11]

Keynes’ point here is to show how limited each individual’s knowledge when compared to the behavior of the market as a whole. To understand the movement of a stock, an investor needs to understand everyone else’s opinion of that stock at the exact moment he chooses to investment. This is an absurd assumption, which Keynes sees happening at a variety of levels. It is a layering of assumptions to the “fourth, fifth and higher degrees.”

Keynes takes this a step further. Not only does the individual have little effect or understanding of the market’s general direction, the stock market, in particular, may be of little use to society. This is a direct deviation from Smith, but Keynes had the benefit of witnessing the stock market collapse that led to the Great Depression. This was more than enough evidence to conclude that the market was essentially instable, the result of widespread speculative behavior that was no different from the mechanics of a casino. The only people earning long-term profits were the brokers, who collect fees on all trades and prey on the gullibility of average investors.

But it’s not just the speculators causing instability. In fact, the general nature of investing is, in fact, instable. Instead of basing our investment decisions on some rational calculation of the utility it may bring us, something much more primal is at work. As Keynes explains,

Our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

The consequences of these motivations are profound. Slumps may be much worse than anticipated, as consumer confidence may lead to the separation of prices from real conditions. The market may rise and fall only because of baseless fears of a change in government. Prices may be entirely wrong.

The Rise of Rational Market Theory

From these foundations, finally, came the emergence of Eugene Fama’s theory of rational markets. While the University of Chicago-based professor doesn’t necessarily disagree with Keynes’s ideas, he states that these errors in market pricing are quickly fixed, as long as the flow of information is fast enough. As he explains,

In a dynamic economy, there will always be new information which causes intrinsic values to change over time. As a result, people who can consistently predict the appearance of new information and evaluate its effects on intrinsic values will usually make larger profits than can people who do not have this talent. The fact that the activities of these superior analysts help make successive price changes independent does not imply that their expected profits cannot be greater than those of the investor who follows some naïve buy-and-hold policy.[12]

Although he allows for some people to beat the market, Fama quickly returns to Keynes. Once there are enough “superior analysts” competing over new pieces of information, the ability for any person to significantly exploit it becomes essentially meaningless. The market cannot be beaten, and prices reflect all available information.

Fama’s theory describes the stock market as a shark tank,[13] whose inhabitants feast on every available new and juicy piece of business information that will allow them to turn a quick profit. When there are only a few sharks, they can easily capture every piece of information and profit. But as the number of sharks increase, it becomes next to impossible for any single shark to stay ahead of the others in the hunt.

The constant flurry of competition results in one of the most essential characteristics of changing stock prices – the random walk. As Fama explains, “the theory of random walks says that the future path of the price level of a security is no more predictable than the path of a series of cumulated random numbers. In statistical terms the theory says that successive price changes are independent, identically distributed random variables.” If prices fluctuate randomly, Fama explains, then it is impossible for any investor to predict the future based on past information.

Fama and his colleagues in Chicago were able to demonstrate in several different empirical studies that the market is capable of turning new information into price adjustments, at least up to a certain degree. Tests of weak-form market efficiency, where market prices properly reflect all previously available market data, provide empirical proof of the relationship between information and prices.[14] The only places where Fama could identify a failure in the movement of information came from corporate insiders and certain specialists that maintained a monopoly on some forms of information.

Fama’s identification of a relationship between information and asset prices led to other breakthroughs in the study of financial markets. Most notably, Fama worked on and extensively tested the Capital Asset Pricing Model, which states that an individual asset’s future price is can be predicted based on the relationship of the asset and the market’s previous fluctuations. Although Fama eventually concluded that other pieces of information needed to be included to get an accurate prediction of the future price,[15] his work showed that the underlining connection between available information and asset prices held.

It’s difficult to understate the influence of Fama’s ideas on the modern practice and study of finance. Staple formulas for MBA classes on finance assume this underlying relationship between prices and information. They include Gordon’s growth model, which is used to predict the future price of a security based on a future dividend, Markowitz’s Modern Portfolio Theory, which shows how diversification can minimize risk, and the Black-Scholes Derivative Pricing Model.

The practice of finance is also based around this profound idea. Financial analysis, stock market indices, and laws on insider trading and company disclosure all play a role in the control and distribution of information. Together, they are meant to make prices more accurate, as investors will be able to quickly react to changes in information and remove inefficiencies.

The Human Side of Markets

The power of Fama’s ideas is also illustrated in the emergence of Behavioral Economics and its leading propent, Richard Thaler. In many ways, this theory can only be thought of as a reaction to the paradigm Fama established. While Behavioral Economics does not seek to dismiss the relationship between information and investor behavior, it does seek to show that prices can be wrong, as Keynes asserted, and that investors do not respond to new pieces of information in rational ways. This assumption in Fama’s model, which in some ways can be brought back to the fundamental problem illustrated by Smith, does not hold in world full of blow-ups, bank runs and crises.

Much of the work that would eventually become Dick Thaler’s brand of Behavioral Economics was started by a pair of psychological researcher named Amos Tversky and Daniel Kahneman. Their work is a return to Keynes’ statement that investors’ actions are not “the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” In the real world, people don’t calculate utility, or often even basic probabilities, instead relying on a series of mental shortcuts called heuristics.

Heuristics serve an important part of our general psychological make-up. They help us process information quickly, and allow us to conserve mental resources when being faced with the thousands of decisions we have to make each day. Unfortunately, while heuristics are very important for our day-to-day living, judgments that utilize heuristics are often wrong and biased.

Much of Kahneman and Tversky’s work is characterized by the many different games and tests they created to show that people often make simple mistakes when faced with uncertainty. One of the typical problems they showed presented the difficulties in assessing probabilities. When given the choice of 450 dollars or a fifty percent chance of winning either zero or 1,000 dollars, a majority of test subjects chose 450.[16] If anyone would take the time to calculate the probabilities, they would find that a fifty percent shot at 1,000 dollars has the higher pay off (five hundred dollars; this is calculated by multiplying the final pay offs with their probability and adding the results). People were regularly making the wrong decisions.

Moreover, people’s flaws in judgment lead them to struggle when assessing risks. As Kahneman and Tversky explain,

Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributed to risk aversion in choices involving sure gains and to rick seeking in choices involving sure losses.

Richard Thaler seized upon these ideas when developing a theory of Behavioral Economics. One of the most profound revelations of his work was that the stock market consistently overreacts. While information continues to affect prices, as Fama pointed out, these reactions are unpredictable and much larger than what the information would dictate. [17] In particular, investors seem to “attach disproportionate importance on short-run economic developments.” This behavior wasn’t limited to uneducated home investors. Even professional forecasters overreacted to the news.

This wasn’t the only piece of irrational behavior in the stock market. Thaler was able to empirically prove the price earnings ratio anomaly, a statistical trend that goes directly against the models based on the Efficient Markets Theory. This anomaly goes something like this: with all other factors being equal, stocks with extremely low price earnings ratios bring much larger risk-adjusted returns than those with high price earnings ratios. Thaler also focused on the January effect, where returns in the first month of the year were consistently better than those in other months. Thaler also showed that people tend to value losses much higher than gains, while choosing to stick to the status quo, whenever possible. This leads to scenarios where highly risky behavior was taken because of nearly “certain” returns.

Other theorists have since joined in the chorus. Nicolas Nassim Taleb, an investor and professor at the Polytechnic Institute of New York, coined the term “Black Swan,” to describe the effect of improbable and unexpected events on people’s behavior.[18] Because black swans are not expected, they tend to have disproportionately large effects. Much of the consequences of black swans come from our biases and judgment errors, many of which were already described by Tversky and Kahneman.

Take together, these new illustrations of people’s inherent flaws place a serious dent in the image of a perfectly operating, rational market. Instead of a well-operating machine churning information into prices, Behavioral Economics sees a world full of panics, mistakes and dramatic swings. With recent events becoming strong vindication for this model, the behavioralists are starting to gain converts. The most shocking of these is Eugene Fama himself, who in a recent paper with French wrote that,

Offsetting actions by informed investors do not typically suffice to cause the price effects of erroneous beliefs to disappear within the passage of time […] The more extreme tangency portfolio produced by the value premium suggests, however that behavioral biases are more prevalent among investors […] The extreme returns of momentum portfolios and the extreme tangency portfolio produced by these returns suggest that relatively little wealth is controlled by informed investors who understand momentum, perhaps because almost all investors are subject to the underreaction to firm-specific information.[19]

In short, Fama’s own research points to how the shark tank metaphor does not actually work in the real world. There are too many mistaken investors, and not enough well-informed investors, for the actions of a few sharks to properly correct mistaken prices. Moreover, the effectiveness of the sharks is compromised because they themselves are victim to biases and incorrect reactions. This, in no lesser terms, is a stunning turn around.

The Fall of High Theory

What does it mean to live in a world where the efficient market theory doesn’t hold? To start, the foundations of modern financial theory have to be openly questioned. All theories stemming from the efficient market theory are inaccurate at best, and at worst, utterly inapplicable to the real world. In fact, when Justin Fox, the writer of The Myth of the Rational Market, contacted Fama to discuss the results of his recent research, Fama answered that if prices were incorrect, calculations on the cost of capital are no longer relevant. “That’s why I don’t teach corporate finance anymore,” is all he could add.[20]
If we follow Fama’s logic, much of academic finance needs to be reassessed. The most problematic models are those that rely on the relationship between an asset and the market, while using the past volatility of an asset to predict future performance. This includes CAPM, the Black-Scholes Model and Modern Portfolio Theory. Their most flagrant problem isn’t that they are inaccurate, it’s that they provide the illusion of precision (turning out numerical values for price fluctuations and risk) when people’s behavior is, by its very nature, anathema to precise prediction. As Henry Poincare wrote a century ago,

When men are brought together, they no longer decide by chance and independently of each other, but react upon one another. Many causes come into action, they trouble the men and draw them this way and that, but there is one thing they cannot destroy, the habits they have of Panurge’s sheep.[21]

At the same time, many behavioralists are not seeking to dismiss the efficient market theory entirely, in part because they have no other place to turn. Accounting for errors in human behavior and wild inaccuracies make it impossible to predict economic phenomena. While everyone understands that the current financial models taught in MBA classes are bad, there is an implicit assumption that there won’t ever be another model that provides a high degree of accuracy. Moreover, the relationship between prices and information still holds. As Fama points out, when people are properly informed, the prices are correct. The problem, then, is that people just don’t have the proper information to base their decisions on. In all likelihood, they never will.

This isn’t the first time this problem has been faced. In fact, Benoit Mandelbrot, the distinguished mathematician who developed fractals, among many other major contributions to modern statistical thought, began criticizing the tools that led to efficient market theory in 1964. Unfortunately, the response to these criticisms was not encouraging.

Mandelbrot, like Prime Minister Churchill before him, promised us not utopia, but blood, sweat, toil and tears. If he is right, almost all our statistical tools are obsolete …, past econometric work is meaningless.[22]

It would benefit us all to return to these roots and reinvestigate the statistical tools that we already knew were lacking. If they prove much of current financial theory wrong, so be it.

References

[1] Taleb, Nicolas Nassim “The Fourth Quadrant: A Map of the Limits of Statistics” Edge: The Third Culture September 15, 2008 http://www.edge.org/3rd_culture/taleb08/taleb08_index.html

[2] Landler, Mark “I.M.F. Puts Bank Losses From Global Financial Crisis at $4.1 Trillion” The New York Times April 21, 2009 http://www.nytimes.com/2009/04/22/business/global/22fund.html

[3] Patterson, Scott “October Pain was ‘Black Swan’ gain” The Wall Street Journal November 6, 2008 http://online.wsj.com/article/SB122567265138591705.html

[4] Zuckerman, Gregory The Greatest Trade Ever Crown Business, November 3, 2009

[5] Fox, Justin The Myth of Rational Markets HarperBusiness. June 9, 2009

[6] Smith, Adam The Theory of Moral Sentiments 6th Edition. London: A. Millar 1790. Section 4, Chapter I, Paragraph 3. http://www.econlib.org/library/Smith/smMS4.html

[7] Smith. Section 4, Chapter I, Paragraph 6.

[8] Smith. Section 4, Chapter I, Paragraph 10.

[9] Arnsperger, Christian and Varoufakis, Yanis “What is neo-classical economics?” post-autistic economics review Issue no. 38, 1 July 2006. Article 1. http://www.paecon.net/PAEReview/issue38/ArnspergerVaroufakis38.htm

[10] Savage, L. J. “Samuelson's Foundations: Its Mathematics” The Journal of Political Economy Vol. 56, No. 3 (Jun., 1948), pp. 200-202 http://www.jstor.org/stable/1825769

[11] Keynes, John Maynard The General Theory of Employment, Interest, and Money. Marxists.org, 2002 http://www.marxists.org/reference/subject/economics/keynes/general-theory/ch12.htm

[12] Fama, Eugene “The Behavior of Stock-Market Prices” The Journal of Business Vol. 38, No. 1. (Jan., 1965), pp. 34-105. http://stevereads.com/papers_to_read/the_behavior_of_stock_market_prices.pdf

[13] This metaphor was originally developed by Scott Patterson in The Quants.

[14] Fama, Eugene “Efficient Capital Markets: A Review of Theory and Empirical Work” The Journal of Finance, Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969(May, 1970), pp. 383-417 http://efinance.org.cn/cn/fm/Efficient%20Capital%20Markets%20A%20Review%20of%20Theory%20and%20Empirical%20Work.pdf

[15] Fama, Eugene and French, Kenneth “The Capital Asset Pricing Model: Theory and Evidence” Journal of Economic Perspectives—Volume 18, Number 3—Summer 2004 —Pages 25– 46 http://pubs.aeaweb.org/doi/pdfplus/10.1257/0895330042162430

[16] Kahneman, Daniel and Tversky, Amos “Prospect Theory: An Analysis of Decision under Risk” Econometrica Volume 47, Issue 2 (Mar., 1979) 263-292 http://www.hss.caltech.edu/~camerer/Ec101/ProspectTheory.pdf

[17] De Bondt, Werner and Thaler, Richard “Does the Stock Market Overreact?” The Journal of Finance Vol. XL, No. 3, July 1985. http://www.jstor.org/sici?sici=0022-1082%28198507%2940%3A3%3C793%3ADTSMO%3E2.0.CO%3B2-Q

[18] Taleb, Nicolas Nassim The Black Swan: The Impact of the Highly Improbable. New York: Random House and Penguin.

[19] Fama, Eugene and French, Kenneth “Disagreement, Tastes and Asset Prices” The Journal of Financial Economics 83 (2007) 667-689 http://wenku.baidu.com/view/1180d9eb6294dd88d0d26b56.html

[20] Fox, Justin The Myth of Rational Markets HarperBusiness. June 9, 2009

[21] Poincare, Henri Science and Method. Dover, 1952

[22] Mandelbrot, Benoit Fractals and Scaling in Finance Springer, New York, 1997