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efficient market theory

Page history last edited by Brian D Butler 14 years, 7 months ago

 

In this page, we will take a look at the "EMH", efficient market hypothesis (vs Behavioural Finance). 

Other links to related GloboTrends pages include:

 

 

Efficient Market Hypothesis:  Background

 

"IN 1978 Michael Jensen, an American economist, boldly declared that “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis” (EMH). That was quite a claim. The theory’s origins went back to the beginning of the century, but it had come to prominence only a decade or so before. Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.  From that idea powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them. And trying to beat the market was a fool’s errand for almost everyone. If the information was out there, it was already in the price.  On such ideas, and on the complex mathematics that described them, was founded the Wall Street profession of financial engineering. The engineers designed derivatives and securitisations, from simple interest-rate options to ever more intricate credit-default swaps and collateralised debt obligations. All the while, confident in the theoretical underpinnings of their inventions, they reassured any doubters that all this activity was not just making bankers rich. It was making the financial system safer and the economy healthier.  read more from The Economist.com

 

 

On the other hand... "BEHAVIOURAL Economics"

 

A strand of sceptical thought, behavioural economics, has been booming.

 

"Behavioural economists were among the first to sound the alarm about trouble in the markets. Notably, Robert Shiller of Yale gave an early warning that America’s housing market was dangerously overvalued. This was his second prescient call. In the 1990s his concerns about the bubbliness of the stockmarket had prompted Alan Greenspan, then chairman of the Federal Reserve, to wonder if the heady share prices of the day were the result of investors’ “irrational exuberance”. The title of Mr Shiller’s latest book, “Animal Spirits” (written with George Akerlof, of the University of California, Berkeley), is taken from John Maynard Keynes’s description of the quirky psychological forces shaping markets. It argues that macroeconomics, too, should draw lessons from psychology.

“In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. read more from The Economist.com

 

Read more from the Economist:  The Social Science Research Network has a paper by Andrew Lo on the efficient markets hypothesis. Myron Scholes, Joseph Stiglitz, Andrei Shleifer, Robert Shiller and Richard Thaler discuss economics.

 

 

 

 

In relation to investing, alpha, exchange traded funds..

 

The concept and focus on Alpha comes from an observation, that around 75 percent of stock investment managers did not make as much money picking investments as someone who simply invested in every stock in proportion to the weight it occupied in the overall market (indexing).

 

Many academics felt that this was due to the stock market being "efficient" (see efficient market theory) which means that since so many people were paying attention to the stock market all the time, the prices of stocks rapidly moved to the correct price at any one moment, and that only luck made it possible for one manager to achieve better results than another, before fees or taxes were considered. A belief in efficient markets spawned the creation of market capitalization weighted index funds that seek to replicate the performance of investing in an entire market in the weights that each of the equity securities comprises in the overall market. The best examples are the S&P 500 and the Wilshire 5000 which approximately represent the 500 largest equities and the largest 5000 securities respectively, accounting for approximately 80%+ and 99%+ of the total market capitalization of the US market as a whole.

 

In fact, to many investors, this phenomenon created a new standard of performance that must be matched: an investment manager should not only avoid losing money for the client and should make a certain amount of money, but in fact should make more money than the passive strategy of investing in everything equally (since this strategy appeared to be statistically more likely to be successful than the strategy of any one investment manager).

 

The name for the additional return above the expected return of the beta adjusted return of the market is called "Alpha".

 

 

Relation to beta

Besides an investment manager simply making more money than a passive strategy, there is another issue:

Although the strategy of investing in every stock appeared to perform better than 75 percent of investment managers, the price of the stock market as a whole fluctuates up and down, and could be on a downward decline for many years before returning to its previous price.

The passive strategy appeared to generate the market-beating return over periods of 10 years or more. This strategy may be risky for those who feel they might need to withdraw their money before a 10-year holding period, for example. Thus investment managers who employ a strategy which is less likely to lose money in a particular year are often chosen by those investors who feel that they might need to withdraw their money sooner.

 

The measure of the correlated volatility of an investment (or an investment manager's track record) relative to the entire market is called beta. Note the "correlated" modifier: an investment can be twice as volatile as the total market, but if its correlation with the market is only 0.5, its beta to the market will be 1.

 

Investors can use both alpha and beta to judge a manager's performance. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly.

 

These concepts not only apply to investment managers, but to any kind of investment.

 

 

 

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