What is the efficient-markets hypothesis and how good a working model is it?

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Fama: It’s a very simple statement: prices reflect all available information. Testing that turns out to be more difficult, but it’s a simple hypothesis.

Thaler: I like to distinguish two aspects of it. One is whether you can beat the market. The other is whether prices are correct.

Fama: It’s a model, so it’s not completely true. No models are completely true. They are approximations to the world. The question is: “For what purposes are they good approximations?” As far as I’m concerned, they’re good approximations for almost every purpose. I don’t know any investors who shouldn’t act as if markets are efficient. There are all kinds of tests, with respect to the response of prices to specific kinds of information, in which the hypothesis that prices adjust quickly to information looks very good. It’s a model—it’s not entirely always true, but it’s a good working model for most practical uses.

Thaler: For the first part—can you beat the market—we are in virtually complete agreement.

Richard Thaler, you give the example of the 1987 crash, when stock prices fell 25 percent, as an example of how prices can be wrong in some sense. But aren’t efficient markets unpredictable?

Thaler: Yes, but unpredictable doesn’t mean rational. I don’t think anyone thinks that the value of the world economy fell 25 percent that day. Nothing happened. It’s not a day when World War III was declared.

Fama: It was a time when people were talking about perhaps an oncoming recession, which turned out not to have happened. In hindsight, that was a big mistake; but in hindsight, every price is wrong.

Thaler: Two of the biggest up days in history occurred that week, and three of the biggest down days occurred. And nothing was happening, other than the fact that people were talking about how markets were up and down like crazy. That’s one indirect way we can measure market efficiency. This was essentially the approach that was pioneered by [Yale’s] Robert Shiller. His argument was, “Prices fluctuate too much to be explained by a rational process.”

Fama: Shiller’s model was based on the proposition that there is no variation through time in expected returns. But we know there is variation in expected returns. Risk aversion moves dramatically through time. It’s very high during bad periods and lower during good periods, and that affects the pricing of assets and expected returns.

Do bubbles exist? How do we define bubbles?

Thaler: I have two examples. The first is house prices. For a long period, house prices were roughly 20 times rental prices. Then, starting around 2000, they went up a lot, then they went back down after the financial crisis.

Fama: What’s the bubble? The up? The down? The subsequent up?

Thaler: We agree that it’s impossible to know for sure whether something’s a bubble. What we do know is that in markets such as Las Vegas; Scottsdale, Arizona; and south Florida, where prices were going up the most, expectations of future price appreciation were also the highest. That could be rational, but I’m skeptical about it.

My second example is the CUBA fund. It’s a closed-end mutual fund that has the ticker symbol CUBA but, of course, cannot invest in Cuba. That would be illegal, and there are no securities [in which to invest]. For many years, the CUBA fund traded at a discount of about 10–15 percent of net asset value, meaning that you could buy $100 worth of its assets for $85–$90. Then, all of a sudden, one day it sells for a 70 percent premium. That was the day President Obama announced his intention to relax relations with Cuba. So securities you could buy for $90 on one day cost you $170 the next day. I call that a bubble.

Fama: That’s an anecdote. There’s a difference between anecdotes and evidence, right? I don’t deny that there exist anecdotes where there are problems. For bubbles, I want a systematic way of identifying them. It’s a simple proposition. You have to be able to predict that there is some end to it. All the tests people have done trying to do that don’t work. Statistically, people have not come up with ways of identifying bubbles.

Thaler: There’s no way to prove which one of us is right. These are the few cases where we can test whether the price and intrinsic value are the same. It shouldn’t be true that shares of the CUBA fund are selling at a 70 percent premium. I would say bubbles are when prices exceed a rational valuation of the securities being traded.

Fama: What’s the test of that?

Thaler: The only tests that are clean are these anecdotes, like closed-end funds, where we know the value of the assets, and we know the price, and we can see that they’re different.

If financial markets are inefficient, where are the biggest inefficiencies?

Thaler: It depends on which definition we’re using. Where are you most likely to be able to beat the market? With smaller firms? In less-developed countries? Although even with those, the advantage that active managers have is relatively small.

Fama: Things that are more systematically tested, that are indications of some degree of market inefficiency, are, for example: the accountants have long established that price adjustment to announcements of earnings is very quick, but not complete. Not enough to make any profits on, but so what? It’s still a slower adjustment that’s an indication that the market’s not completely efficient. The whole momentum phenomenon gives me problems. It could be explained by risk, but if it’s risk, it changes much too quickly for me to capture it in any asset-pricing models.

The point is not that markets are efficient. They’re not. It’s just a model. The question is, “How inefficient are they?” I tend to give more weight to systematic things like failure to adjust completely to earnings announcements, or momentum, than to anecdotes, which are curiosity items rather than evidence.

You agree about the fact that value stocks tend to outperform growth stocks, but you have different explanations? What are your explanations and evidence?

Fama: Value stocks are just riskier than growth stocks. You can’t really establish that unless you can tell me why this source of variance carries a different price per unit than other sources of variance. I think that’s an open issue at this point.

Thaler: I pretty much agree with that. I’ve looked hard to find ways in which value stocks are riskier than growth stocks, and I’ve been unable to find them. I think value firms look scary, and they get a premium for that.

Fama: They don’t have to look scary. Another story is that people just don’t like them. Economists don’t argue about taste. Value stocks tend to be companies that have few investment opportunities and aren’t very profitable. Maybe people just don’t like that type of company. That to me has more appeal than a mispricing story, because mispricing, at least in the standard economic framework, should eventually correct itself, whereas taste can go on forever.

Thaler: I don’t think you can call it taste.

Fama: I’m not saying I can call it that based on evidence. It just appeals to me more than a mispricing story.

Thaler: Suppose you say you like $20 bills, and you’re willing to take four $20 bills for $100: now that’s taste.

Fama: That’s an arbitrage.

Thaler: The question is, the people who dislike value stocks, and that’s just [because of] taste, and it’s wrong . . .

Fama: It’s not wrong. Remember now, we’re economists. You’re a behavioralist, that’s even worse. You don’t comment on people’s taste.

Thaler: I do when they say that they like four $20 bills better than a $100.

Fama: That’s an arbitrage. That’s different. Suppose I tell you I like apples better than oranges.

Thaler: Then that’s taste.

Fama: OK, that’s value stocks and growth stocks. I’m not arguing for it; I’m just saying it’s a possibility.

Thaler: We’re both affiliated with asset-management firms that invest in small-value stocks. We’re hoping to earn high returns—and do achieve that goal more often than not. If we’re buying those stocks because people don’t like them, we’re only going to make money if they change their minds.

Fama: Some people change their mind.

Thaler: I think you’re more behavioral than me now!

Fama: I’m an economist. Economics is behavioral, no doubt about it. The difference is your concern is irrational behavior; mine is just behavior.

Thaler: The distinction I make is whether behavior is predictable from a rational model. I’m willing to include behavior that is not predicted by a rational model.

Fama: I would agree with that.

Thaler: We’re both interested in understanding the world. I have some prurient interest in things like the CUBA fund. I think we would both like to know what caused housing prices [to go] up so fast and then back down.

Fama: And then back up again.

Thaler: If those prices were wrong in some sense, it would be good to know . . . If I were the chair of the Fed, or in charge of Freddie Mac or Fannie Mae, if I saw the price of homes in places like Vegas and Scottsdale going up so fast in the early 2000s, I would be raising lending requirements.

So policy makers should use bubbles as a way to step in?

Thaler: Yes, but very gently. It’s not like I think policy makers know what’s going to happen, but if they see what looks disturbing, they can lean against the wind a little bit. That’s as far as I would go. We both agree that markets, good or bad, are the best thing we’ve got going. Nobody has devised a way of allocating resources that’s better.

Fama: We disagree about whether policy makers are likely to get it right, though. On balance, I think they are likely to cause more harm than good.

What impact has behavioral science had on economics?

Fama: Twenty years ago my criticism of behavioral finance was that it is really just a branch of efficient markets, because all they do is complain about the efficient-markets model. I’m probably the most important behavioral-finance person, because without me and the efficient-markets model, there is no behavioral finance. I still think there is no full-blown testable behavioral asset-pricing model.

Thaler: The efficient-markets hypothesis remains the standard. That’s true of all economic models, but people don’t make decisions that way. In my managerial-decision-making class, I give [the students] rules at the end of class. One is, “Ignore sunk costs; assume everyone else doesn’t.” That’s my philosophy of life. I believe the rational model, and I think that a lot of people screw it up, and that we can build richer models with a better predictive power if we include the way people actually behave as opposed to [the behavior of] fictional “Econs” that are super smart and have no self-control problems. I don’t know anybody like that.

Will there be an overarching theory of behavioral economics that other people can try to reject?

Thaler: No. There won’t be a new overarching theory. We’ve got one. It just happens to be wrong.

Fama: Like all theories.

Thaler: It’s not going to be like the Copernican Revolution, where having the Earth in the middle was clearly wrong, and having the Sun in the middle was right. It’s going to be more like engineering. Physics, in its pure form with lots of assumptions, doesn’t build good bridges. You need engineering. That’s what the behavioral approach to economics is.

How does this debate affect regular investors?

Fama: When [Princeton’s] Daniel Kahneman got the Nobel Prize, he was asked how investors should behave. He basically said, “They should buy index funds.” The behavioralists come from a different perspective, because they think everybody is irrational, so the only way to make them rational is tell them what to do that’s possibly rational. Whereas I think the rational thing to do, because prices reflect available information pretty much, is to be a passive investor.

Thaler: If there’s a nonacademic point about this, it’s whether things like the rise of technology stocks in the late 1990s—in Gene’s honor I won’t refer to it as a bubble—are a misallocation of resources.

Fama: In hindsight it was.

Thaler: Was that a misallocation of resources? We would like to know that. We had Booth students quitting after one year to go out and make their billion, and most of them didn’t. As Gene would say, when ex post, it did look like a bubble. I’m not saying we can recognize [bubbles] when they’re happening, although I’m working on that, but I do think that we can have a pretty good hunch. A bubble-detection committee would be highly useful if it were reliable. We’re not there yet.

Fama: In general, it would be useful to know to what extent all economic outcomes are due to rational and irrational interplays. We don’t really know that.