The EMH and Me

Following the 2008 financial crisis, a small cottage industry emerged to critique some of the economic theories that were somehow accountable for the institutional problems America faced. One of the most prime targets was the Efficient Markets Hypothesis, a theory that has been used to both justify and condemn just about every possible financial activity.

I think a lot of us here would argue against the strong ideological implications of the efficient market hypothesis, at least until our libertarian friends start spamming the comments. But the political aspects of the EMH do an incredible disservice to the empirical reality that Eugene Fama described: it is practically (but not entirely) impossible for investors to regularly outperform the market.

This simple but powerful idea drove the formation of an entire industry's worth of index funds, which remain, by far, the best possible investment vehicle for individuals.

Congrats on your Nobel Dr. Fama. It is well deserved.

Cochrane sums it all up beautifully:

Gene’s ideas are alive, and his contributions define our central understanding of financial markets today. His characterizations of time varying bond, stock, and commodity returns, and the three-factor model capturing value and size effects remain the baseline for work today. His characterization of predictable foreign exchange returns from the early 1980s is still one of the 2 or 3 puzzles that define international finance research. The critics still spend their time attacking Gene Fama. For example, researchers in the “behavioral finance” tradition are using evidence from psychology to give some testable content to an alternative to Gene’s efficient market ideas, to rebut caustic comments like mine above about “fads.” This is remarkable vitality. Few other idea from the early 1970s, including ideas that won well-deserved Nobel prizes, remains an area of active research (including criticism) today.

Of course, some will say that the latest crash "proves" markets aren't "efficient." This attitude only expresses ignorance. Once you understand the definition of efficiency and the nature of its tests, as made clear by Gene 40 years ago, you see that the latest crash no more "proves" lack of efficiency than did the crash of 1987, the great slide of 1974, the crash of 1929, the panic of 1907, or the Dutch Tulip crisis. Gene's work, and that of all of us in academic finance, is about serious quantiative scientific testing of explicit economic models, not armchair debates over anecdotes. The heart of efficient markets is the statement that you cannot earn outsize returns without taking on “systematic” risk. Given the large average returns of the stock market, it would be inefficient if it did not crash occasionally.

Gene’s work has had profound influence on the financial markets in which we all participate.

For example, In the 1960s, passively managed mutual funds and index funds were unknown. It was taken for granted that active management (constant buying and selling, identifying "good stocks" and dumping "bad stocks") was vital for any sensible investor. Now all of us can invest in passive, low cost index funds, gaining the benefits of wide diversification only available in the past to the super rich (and the few super-wise among those). In turn, these vehicles have spurred the large increase in stock market participation of the last 20 years, opening up huge funds for investment and growth. Even proposals to open social security systems to stock market investment depend crucially on the development of passive investing. The recognition that markets are largely “efficient,” in Gene’s precise sense, was crucial to this transformation.

Unhappy investors who lost a lot of money to hedge funds, dot-coms, bank stocks, or mortgage-backed securities can console themselves that they should have listened to Gene Fama, who all along championed the empirical evidence – not the “theory” – that markets are remarkably efficient, so they might as well have held a diversified index.