Learning to live with not-so-efficient markets

For most non-economists, the biggest intellectual casualty of the 2007–2008 financial crisis is the efficient market theory (EMT). Newspapers and talk shows have analyzed the theory’s apparent demise; new books with titles like How Markets Fail, The Myth of the Rational Market, and A Failure of Capitalism abound. Yet, in academia, the EMT has been challenged since the 1987 stock market crash, and the theoretical and empirical shortcomings of the theory have been well established. The marginal contribution of the 2007–2008 financial crisis was to weaken the already-losing side of hardcore believers in the EMT.

Thus far, the recent crisis has not provided any crucial new evidence on the deviations of markets from fundamentals, only evidence of the costs of these deviations, especially when coupled with very high leverage. The rise and collapse of the real estate market, with all the consequences these events produce, are much easier to explain as the result of variation in fundamentals than is a 22.6 percent stock market drop in a day with no major news. Hence, those who have remained unchanged in their beliefs since the 1987 stock market crash have been little affected in their faith by the 2007–2008 financial crisis or by the evidence collected in the intervening twenty years. Yet the increasing proportion of academics who question the EMT have found in the recent crisis a painful example of the costs of ignoring potential market inefficiencies. A major rethinking of the validity of the theory’s implications is all but inevitable.

From courtrooms to boardrooms, from policy cabinets to classrooms, the EMT provided the intellectual foundation for an entire generation. The current debate has thrown this foundation into question. Rethinking the theory, however, does not mean abandoning it: the approach still holds many useful insights. Because it has provided a coherent framework with great practical value, rethinking the EMT will be painful; nonetheless, it is necessary. This journey will inevitably be full of mistakes, but the biggest mistake of all would be not to undertake it.

While its intellectual origin can be traced back to the early twentieth century, the EMT hypothesis gained importance in academia in the mid-1960s. In its early formulation, the EMT was simply the idea that if prices adjust rapidly to new information, they should be unpredictable. This hypothesis, validated by economist Eugene Fama’s dissertation at the University of Chicago in 1965, has three very important implications. First, if prices are unpredictable, then all technical analysis, which uses past price behavior to predict future trends, is useless. Second, if prices are unpredictable, then investors should not pay for investment advice and active money management, but should simply buy mutual funds that passively track the stock market index. Last but not least, if future prices are unpredictable, current prices are the best available estimate of the true value of any asset. If this were not the case, so the theory goes, speculators would intervene to drive prices equal to fundamentals.

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