Markets are mostly efficient

I just stumbled on this interesting discussion between Eugene Fama and Richard Thaler – they talked about whether markets are efficient or not.

Thaler argues that markets are not efficient. Fama agrees, but nonetheless are argue that we have no better model of the world. It shouldn’t be a surprise to my readers that I agree more with Fama than Thaler.

What I particularly notice is just how little evidence Thaler is able to present that markets are not efficient. Yes, he comes up with anecdotes, but that is not evidence. With billions of investors and billions of different markets and prices you will always be able to come up with some example of pricing behavior, which in someway looks inefficient or irrational, but that does not mean that you generally can say markets are inefficient rather than efficient.

My own view is very much based on my experience from working more than 15 years in financial markets. So even though I theoretically always have had a lot of sympathy of Euguene Fama’s thinking about financial markets it is not really the theoretical arguments that convince me these days.

It is simply my experience that I never meet anybody in the financial markets who consistently have been able to beat the markets. I met a lot of people who think they can beat the market, but that is not the same as they are right (they are not).

Obviously with billion of people around the world making decision and investments some will for periods do better than others, but this is essentially down to luck (or inside information!).

One thing that particularly has convinced me that markets are mostly efficient is my empirical work on exchange rates. The models I have build over the years has shown me that the more information about the world I get into the model the better the models are. The interesting thing has been that the more information I have incorporated into the empirical models the closer the “forecast” from these models have come to market expectations of future exchange rates.  Furthermore, my experience with the typical bank analysts’ forecasts of exchange rates I have learned that they rarely outperform market expectations.

This has shown me that most available information mostly is also reflected in the exchange rate and as a consequence I have had to come to the conclusion that I probably not will be able to beat the markets. And try to think about it – with billions of people trying to forecast the future exchange rate why would I be able to do better than the average forecast? What information do I have that they don’t? The Efficient Market Hypothesis (EMH) essentially is about being humble about your own abilities.  

What do both Fama and Thaler miss? I notice that both of them completely miss the importance of changes in policy – particularly in monetary policy. Simple forward-looking behavior of for example the stock markets or FX markets will show that even fairly small changes in the expected future growth rate of consumer prices or nominal incomes can have very large impact of for example the spot exchange rate if prices are rigid.

An example of this is Dornbusch’s famous overshooting model for exchange rate determination. In Dornbusch’s model there can be large fluctuations in the exchange rate, but it does not reflect inefficient markets or irrational behavior, but completely rational forward-looking behavior.

Believing that markets are mostly efficient is not assuming somekind of superhuman abilities. It is simply a matter of acknowledging the fact that billions of peoples’ knowledge are very well reflected by the price system. There is no better mechanism for aggregating information and there exist no better mechanism for aggregating information than the price mechanism.

As Eugune Fama stresses – the Efficient Market Hypothesis (EMH) – is a theory and as such is not 100% correct as it is exactly a theory, but so far no economist has come up with any theory that describes the world better than EMH and I see very little reason to think that that will change anytime soon.

Update: Apparently somebody are able to beat the market in a dramatic fashion. Just see the impressive trading performance of US Democrat Congresswoman Judy Chu. I am not making any judgements here other than noting that this is a politicians and not a regular trader. Another Democrat also once had a fantastic trading record.

Leave a comment


  1. Matthias

     /  August 3, 2016

    “Furthermore, working the typical bank analyst forecasts of exchange rates I have learned that they rather outperform market expectations.”

    You probably wanted to write “rarely”?

  2. If someone tells you markets are inefficient in some discernible, predictable, systemic way, they should be able to explain why this perspicacious investing model hasn’t yet turned them into trillionaires, or at least explain how anyone armed with their model could do so.

    Thaler seems to have conceded the argument before he begins by admitting he does not have such or model or even believe such is possible. He tries to limit his argument to “prices are incorrect” but if they are incorrect based on the available information, then such a model should be possible.

    The 1987 stock market crash was not necessarily mispriced at the time — things could have turned out very differently if the Fed had taken a hard line. I was very young but I remember the panic in ordinary people’s eyes and the relief when the Fed promised liquidity would be provided.

    Utility lies in the eyes of the beholder. Prices are fundamentally a psychological phenomenon, so yes, fear makes some things less valuable.

  3. Also, it’s not true nothing was happening on Oct 20, 1987. The whole thing started in Asia, ironically perhaps due to some monetary policy comments by James Baker.

  4. An alternative argument for the EMH is that markets reallocate resources from those who are worse than average at forecasting to those who are better than average. For a market to remain persistently inefficient, there would have to be some non-market mechanism to transfer resources back to the worse-than-average forecasters.

  5. I’m convinced of the lack of alternative, but I don’t believe in the perfect human predicting the future. I think that financial cannot be efficient because of the high asymmetry in information. I can’t userstand how you explain 2007-2008 as proof of EMH. Really impossible.


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