The efficient market hypothesis is a deeply flawed theory.
When was asked why he robbed banks, gentleman robber Willie Sutton is alleged to have replied; "because that's where the money is." Sutton's modern-day equivalents are the "banksters" who invested in so-called "toxic assets", bankrupting their employers whilst scooping multi-million dollar bonuses for their negligence.
But why did they do this? Leaving asides personal greed, it's easy for the banksters to claim that they did nothing wrong because they were following one of the major theories of modern finance; the "efficient market hypothesis" (EMH), for which several Nobel Prizes have been awarded. The problem with this argument is that EMH is a flawed theory.
Efficient Markets
EMH originated with Eugene Fama's PhD thesis in 1965 and can be summed up in one sentence; the price of a financial asset is always correct.
Unless you are taking an economics course there are two types of EMH, "weak" and "strong." In weak EMH market prices accurately reflect all publicly available information but take time to adjust to new information. Essentially weak EMH tells us that prices of assets are "mostly right" and this provides the theoretical support behind the idea that the average investor will be better off investing in a tracker fund because investors as a whole cannot outperform the market. As Warren Buffett says regarding tracker funds, "when dumb money acknowledges its limitations it ceases to be dumb."
But strong EMH holds that markets always instantaneously and accurately process new information, thus the market will always produce the correct price for any financial asset.
Having A Nobel Prize Doesn't Make You Right
The problem is that, as history has shown us, markets can sometimes be very inefficient. The academics' mistake was going from weak EMH ("mostly right") to strong EMH ("always right") and thus incorrectly assuming that asset prices will always be correct.
Proof that strong EMH was seriously flawed was provided in 1998 with the collapse of the hedge fund Long-Term Capital Management (LTCM), two of whose directors had won the 1997 Nobel Prize for Economics. LTCM operated by taking advantage of small price differences between different nations' government bonds, following mathematical models based on strong EMH.
EMH failed here because of the panic which appeared in global bond markets during the Russian financial crisis, invalidating the assumption that markets will always provide sufficient liquidity to buy financial assets. So market prices deviated from their value as predicted by strong EMH and LTCM went down the tubes.
If you absolutely had to sell your house in three days would you seriously think that you could get the market price for it? Apparently LTCM thought so.
Toxic Assets
If you lend money to someone to buy a house, knowing that they are unlikely to pay it back, you wouldn't consider this loan as being a secure investment. Yet packages of thousands of these "NINJA loans" (No Income, no Job, no Assets) could be turned into a triple-A rated investment, theoretically as secure as US Government debt, by the credit rating agencies' strong EMH-based mathematical models.
So as investors were prepared to pay triple-A prices for these mortgage-backed securities strong EMH said that this was the correct price. Never mind that common sense would say that these toxic assets were overpriced junk, akin to putting lipstick on a pig.
The flood of money into the American housing market pushed up prices, which in turn encouraged more lending (and more house building). A magic money machine had been created, lending money to deadbeats and the "financially challenged" became highly profitable and these toxic assets were resold all over the world. Of course, when these loans started to go bad the truth came out; the risk of default had been massively underpriced and the result was the credit crunch.
You Are Not Hari Seldon
The science fiction writer Isaac Asimov is best known for his three laws of robotics. Asimov also wrote a series of books, Foundation, in which the scientist Hari Seldon develops the mathematical theory of "psychohistory" which foresees the collapse of the Galactic Empire. Seldon foresaw a period of barbarism lasting for more than thirty thousand years before the Second Empire arose, so he used his mathematics to establish a Foundation to shape the future and limit the dark ages to a thousand years.
I'm convinced that many of the academics involved with EMH thought that they were the Hari Seldons of our time, believing that their formulae would predict the behaviour of entire populations. They were wedded to the theory of Homo Economicus, "economic man", who always acts rationally and perfectly processes information to produce the correct price.
But the field of behavioural economics tells us that people are often irrational and commonly process information incorrectly. For example, most people massively overestimate the probability of very-low probability events, such as getting hit by lightning.
EMH Puts The Boot In
Having caused many of the problems in the first place, EMH really put the boot in when the secondary market in toxic assets collapsed. As fear stalked the markets many investors were forced to dump their investments for a fraction of their worth; this in turn affected the prices in other markets and produced some absurdly low prices.
The problem was magnified because accounting rules required that these assets were valued at the market price, even where there was no market because of the ongoing panic! The effect was to bring down Lehman Brothers in September 2008, triggering tremendous problems in global financial markets and plunging the world into a deep recession.
Thankfully, common sense prevailed and these mark-to-market rules have since been relaxed.
Beware academics bearing formulae that claim to predict human behaviour.
More on Tony Luckett:
