Eugene Fama has written an autobiographical account of his contributions to financial economics. Without doubt the man is a giant in his field. This is what he says about the EMH.
At the end of my second year at Chicago, it came time to write a thesis, and I went to Miller with five topics. Mert always had uncanny insight about research ideas likely to succeed. He gently stomped on four of my topics, but was excited by the fifth. From my work for Harry Ernst at Tufts, I had daily data on the 30 Dow-Jones Industrial Stocks. I proposed to produce detailed evidence on (1) Mandelbrot’s hypothesis that stock returns conform to non-normal (fat-tailed) stable distributions and (2) the time-series properties of returns. There was existing work on both topics, but I promised a unifying perspective and a leap in the range of data brought to bear.
Vindicating Mandelbrot, my thesis (Fama 1965a) shows (in nauseating detail) that distributions of stock returns are fat-tailed: there are far more outliers than would be expected from normal distributions – a fact reconfirmed in subsequent market episodes, including the most recent. Given the accusations of ignorance on this score recently thrown our way in the popular media, it is worth emphasizing that academics in finance have been aware of the fat tails phenomenon in asset returns for about 50 years.
My thesis and the earlier work of others on the time-series properties of returns falls under what came to be called tests of market efficiency. I coined the terms “market efficiency” and “efficient markets,” but they do not appear in my thesis. They first appear in “Random Walks in Stock Market Prices,” paper number 16 in the series of Selected Papers of the Graduate School of Business, University of Chicago, reprinted in the Financial Analysts Journal (Fama 1965b).
From the inception of research on the time-series properties of stock returns, economists speculated about how prices and returns behave if markets work, that is, if prices fully reflect all available information. The initial theory was the random walk model. In two important papers, Samuelson (1965) and Mandelbrot (1966) show that the random walk prediction (price changes are iid) is too strong. The proposition that prices fully reflect available information implies only that prices are sub-martingales. Formally, the deviations of price changes or returns from the values required to compensate investors for time and risk-bearing have expected value equal to zero conditional on past information.
During the early years, in addition to my thesis, I wrote several papers on market efficiency (Fama 1963, 1965c, Fama and Blume 1966), now mostly forgotten. My main contribution to the theory of efficient markets is the 1970 review (Fama 1970). The paper emphasizes the joint hypothesis problem hidden in the sub-martingales of Mandelbrot (1966) and Samuelson (1965). Specifically, market efficiency can only be tested in the context of an asset pricing model that specifies equilibrium expected returns. In other words, to test whether prices fully reflect available information, we must specify how the market is trying to compensate investors when it sets prices. My cleanest statement of the theory of efficient markets is in chapter 5 of Fama (1976b), reiterated in my second review “Efficient Markets II” (Fama 1991a).
The joint hypothesis problem is obvious, but only on hindsight. For example, much of the early work on market efficiency focuses on the autocorrelations of stock returns. It was not recognized that market efficiency implies zero autocorrelation only if the expected returns that investors require to hold stocks are constant through time or at least serially uncorrelated, and both conditions are unlikely.
The joint hypothesis problem is generally acknowledged in work on market efficiency after Fama (1970), and it is understood that, as a result, market efficiency per se is not testable. The flip side of the joint hypothesis problem is less often acknowledged. Specifically, almost all asset pricing models assume asset markets are efficient, so tests of these models are joint tests of the models and market efficiency. Asset pricing and market efficiency are forever joined at the hip.
I also enjoyed this bit from the foreword.
Finance is the most successful branch of economics in terms of theory and empirical work, the interplay between the two, and the penetration of financial research into other areas of economics and real-world applications.
Well, I hope you are being ironic. I wonder what Fama’s definition of ‘successful’ is. None of Markowitz, CAPM or Miller-Modigliani is taken seriously in the industry. Black-Scholes is better but not really used all that much either.
On the other hand, lots and lots of traditional economics is used evey day in a myriad of small ways. In fact it informs policy choices, not to mention monetary and fiscal policy. So, you know, ‘most successful’ is a big call. And I have not even started on the theoretical underpinnings.
Ilya
5 Mar 10 at 1:25 pm
That last quote struck me as absolute nonsense too.
Normal industry micro is the most successful and widely used area of economics. Academic finance has been mostly discredited – Taleb is right.
jtfsoon
5 Mar 10 at 1:34 pm
The first quotation block is possibly the most sensible passage that I have ever read about the EMH.
The second is much more problematic. It certainly wouldn’t stand up empirically. I’m with Jason and Ilya on this.
Dandy Warhol
5 Mar 10 at 1:56 pm
“None of Markowitz, CAPM or Miller-Modigliani is taken seriously in the industry. Black-Scholes is better but not really used all that much either. ”
What utter rubbish.
Steve Edney
5 Mar 10 at 1:57 pm
The problem with academic finance though is probably that its used too much, not that its not used.
Steve Edney
5 Mar 10 at 1:58 pm
Steve, I’d like to see some evidence of say MM taken seriously outside of the academia.
Ilya
5 Mar 10 at 2:08 pm
Did you see Markets are efficient if and only if P = NP?
James
5 Mar 10 at 2:22 pm
MM I have no evidence for and if I could have been bothered would have removed from the quote. The rest I stand by. Black scholes usage I know best and its is very widely used.
Steve Edney
5 Mar 10 at 2:23 pm
From the Financial Times 29 October 2009
Sinclair Davidson
5 Mar 10 at 3:24 pm
The CAPM and Black Scholes are both widely used in the market.
sdfc
5 Mar 10 at 9:31 pm
Whether the business is financed by debt or equity should not, according to the M&M theorem, affect its market value.
That’s an interesting proposition, however I would tend to argue that equity gives you the staying of not having to take the first bid that comes along in a firesale.
JC
5 Mar 10 at 9:51 pm
SDFC:
As someone mentioned Black scholes is still around.
We once had a professor from an Ivy league sit with us for a long time trying to figure out what we were doing to make money. At the end of the period he accepted that it was just random. He sent me his paper but I can’t recall what he came up with.
JC
5 Mar 10 at 9:54 pm
“Whether the business is financed by debt or equity should not, according to the M&M theorem, affect its market value.”
How’d that work out for Babcock & Brown?
Semi Regular Libertarian
5 Mar 10 at 9:55 pm
I heard Stephen Ross tell a room full of people that the EMH hypothesis is hyper correct and the market never gets it wrong, but the entirety of market participants can get it wrong.
Semi Regular Libertarian
5 Mar 10 at 9:57 pm
The market mainly gets it wrong when expectations run away from reality.
sdfc
5 Mar 10 at 10:00 pm
Ilya
I learnt all these Finance theories in my MBA, including econometric studies both pro and con. All of these theories are taken very seriously in the commercial/financial worlds, but they are done so critically, ‘under advisement,’ ‘to a certain extent,’ ‘not in these circumstances’ and so on.
You need to appreciate the different aims, assumptions, and intentions of abstract and theoretical scholarship, and the more chaotic, opportunistic diversity of human global commerce.
I remained extremely impressed by the intuition of EMH, and use its insights as a heuristic all the time. But I still cannot grasp what it is that all this ‘two minutes of hate’ towards Fama is trying to achieve. Unless these activists can replace Fama’s market/portfolio/information efficiencies with a superior agent, then they are just pissing in the wind.
Peter Patton
5 Mar 10 at 10:34 pm
…..but the entirety of market participants can get it wrong.
Which for a trader when he gets that right is like a double shot of heroin.
You only get that feeling infrequently.
JC
5 Mar 10 at 10:41 pm
SRL:
I think they’re saying the value of the business is still being correctly measured in terms of the equity of the debt.
I think it’s broadly correct in theory. In practice it’s another thing.
JC
5 Mar 10 at 10:43 pm
Hate to disappoint you but the EMH is not even theoretically robust, let alone practically. It is an interesting thought, as Peter points out, but the reality is it does not work theoretically (Stiglitz-Grossman and Fama/French should be enough to put that to rest) and neither does it reflect what happens in practice (I see we have an entire industry of analysts whose role is to reduce assymetries, would not need them if the EMH held up).
So, saying that financial economics is ‘most successful’ is plain silly. It is only partially used and widely disbelieved. Hardly a sign of success. And certainly not relative to other field of economics which are indeed widely used and whose fundamentals are not questioned (the debate is largely about variables not fundamentals).
All we have in response is the self-referential ‘Whether the business is financed by debt or equity should not, according to the M&M theorem, affect its market value.’ According to MM, yes, according to practioners, not so much. ‘Not entirely loopy’, yes, but this is cold comfort.
Ilya
6 Mar 10 at 12:05 am
Dead right Ilya. But best at this point to don some armour, I think. Sinclair is a believer.
Dandy Warhol
6 Mar 10 at 8:56 am