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Business News/ Opinion / The efficient markets fad
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The efficient markets fad

Stock markets are inherently unstable and inefficient. They need leashing but policymakers are actively fanning them

2013 Nobel Prize laureates in economic sciences Eugene Fama (L-R), Lars Peter Hansen and Robert Shiller. Photo: Claudio Bresciani/ReutersPremium
2013 Nobel Prize laureates in economic sciences Eugene Fama (L-R), Lars Peter Hansen and Robert Shiller. Photo: Claudio Bresciani/Reuters

The 2013 Nobel prize for economics has been awarded to three academics—Hans Larsen, Eugene Fama and Robert Shiller. Larsen specialized in econometric verification of economic theories. Fama and Shiller focused on the efficiency of financial markets, primarily those dealing with equities. Fama is attached with the University of Chicago, the ideological fountainhead of pro-market economics. Shiller is with Yale University and has cast many an agnostic glance at the gods of free (financial) markets. Quite what is the message of this prize escapes your humble columnist.

Fama is associated with the theory of efficient financial markets. It has two related features. One is the informational efficiency of financial markets. It is that asset prices reflect all known public information instantaneously and continuously. If prices reflect all the information, then there is no incentive to buy or sell assets unless one has price-sensitive and price-relevant information that the public does not know about. The implication of the informational efficiency of markets is that violent price movements (crashes or bubbles) cannot coexist with informational efficiency.

A market crash repudiates the efficient markets theory because a crash is a catch-up on the part of the market with information unless that information was really news to the market. Therefore, a crash reveals that financial markets (and investors) have not been linearly and continuously discounting relevant information. In other words, asset prices had decoupled from information (and got coupled with noise). That is what a crash proves.

It follows from the theory of informational efficiency of markets that stock prices are a random walk or that stock returns are normally distributed with mean zero. Clearly, crashes and bubbles show that returns have fat tails, more extreme outcomes than one would expect in a normally distributed variable.

Informational efficiency also means that it should not be possible for money managers to generate super-normal returns from investing in financial markets. The only return that investors can earn from investing in stocks should be proportional to the beta of the stock return—its sensitivity to the return on the market portfolio. Returns from a single stock can be higher than the return on the truly representative market portfolio of all risky assets only if investors were willing to bear the risk of higher losses than on the market portfolio. In other words, if the beta of the stock is greater than one, only then the stock can deliver higher returns (or suffer higher losses).

But, there is an active and thriving industry of fund managers, claiming to earn alpha (returns not attributed to or attributable to return on the market portfolio) and investors are willing to pay fees in search of that alpha. The robust health of the active fund management industry disproves the feature of the market efficiency hypothesis—that one cannot earn more returns than on the market portfolio except by taking higher risk.

Going back to the informational efficiency aspect of the theory of efficient financial markets, one should remember that it presupposes that both buyers and sellers have access to the same information at the same time. Changes to how stockbrokers earned their income completely destroyed the foundation of informational efficiency of financial markets. Brokers used to earn income from commissions paid by buyers and sellers of stocks in the secondary market. Thus, they did independent research on stocks and made recommendations on stocks to buy and sell.

As competition increased in the stockbroking industry—by design or default—commissions dwindled. Brokers turned to other sources of revenue. They turned to investment banking services, which shifted their loyalties towards corporations away from clients who paid for research and advice on investing in stocks. It also meant the market was deprived of crucial information relevant to making investment decisions.

Egregious examples include the behaviour of brokers who peddled stocks even while calling them worthless (and worse) in internal emails. A case in point is that of Enron where most analysts maintained strong buy ratings on the stock right up to the minute the company went bankrupt. Similar is the story with WorldCom. With the withholding of relevant information, price discovery process in stock markets cannot be and has not been efficient.

For markets to be efficient, there should be no restrictions on short-selling of stocks. But, when in trouble, not only regulators but companies too want short-selling to be banned. So much for letting markets function.

Investors in stocks chase rising prices higher and follow falling prices lower. Stock markets are thus inherently unstable and inefficient. They need to be leashed.

In other words, policymakers have to constantly counterbalance the pro-cyclical tendency of financial markets. It is a different matter that policymakers are actively fanning them today.

Like all theories in social sciences, the theory of efficient markets was, at best, a point of departure to analyse the real world. At worst, it was a comprehensive misrepresentation of reality.

V. Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution. Comments are welcome at baretalk@livemint.com.

To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk

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Published: 21 Oct 2013, 08:25 PM IST
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