Tuesday, October 15, 2013

Are Markets Efficient or Irrational?

My wife, son and I took advantage of yesterday's splendid fall weather to hike Mt. Monadnock in New Hampshire.  We're a little sore today - climbing to the summit is pretty daunting - but had a terrific time.
Earlier this week it was announced that this year's Nobel Prize in economics would be awarded to three American academics:  Robert Shiller, Eugene Fama and Lars Peter Hansen.

The men are being recognized for their pioneering work in trying to describe how markets work.  Interestingly, although they shared the award, Fama and Shiller fundamentally disagree in their conclusions.

Here's an excerpt from the New York Times:

Mr. Fama’s seminal theory of rational, efficient markets inspired the rise of index funds and contributed to the decline of financial regulation. Mr. Shiller, perhaps his most influential critic, carefully assembled evidence of irrational, inefficient behavior and gained a measure of fame by predicting the fall of stock prices in 2000 as well as the housing crash that began in 2006...

The three economists, who worked independently, were described as collectively illuminating the workings of financial markets by showing that stock and bond prices move unpredictably in the short term but with greater predictability over longer periods. The prize committee said these findings showed that markets were moved by a mix of rational calculus and irrational behavior. 

Yet in jointly honoring the work of Mr. Fama and Mr. Shiller, the committee also highlighted how far the economics profession remains from agreeing on the answer to a basic and consequential question: How do markets work? 


Writing in the Atlantic magazine, Derek Thompson makes the excellent point that while Shiller and Fama might disagree on whether markets are irrational or efficient, they both agree that it is pointless to try to guess the short term movements of any markets:

If Fama and Shiller's research disagrees about the short term, they meet, like fundamentals and asset prices, in the long run. Shiller's research showed that periods of over-enthusiasm about a stock tend to follow periods of under-enthusiasm about a stock. The year-to-year gyrations seem wild and capricious. But the fact that they follow a pattern over the course of many years suggests that, in the long run, stocks reflect certain fundamentals, like expected future earnings.
These findings might strike you as familiar advice. They reflect the position of some financial advisors who tell families that frenetic day-in-day-out activist investing is for chumps, and the best place for your money is a passively managed portfolio or index fund.

But it's a disquieting idea for most of the financial news industry, whose 24-7 coverage of the market implicitly presumes an audience seeking guidance about which stocks to buy and sell each day. Daily, monthly, and annual stock picks are low-probability gambles according to Fama and Shiller's research. But they're the bread-and-butter of financial media.


So perhaps the most important conclusion from this year's Nobel winners is to turn off the television commentators and other financial media and focus on longer term trends.