Efficient markets theory has lost its lustreby Jonathan Derbyshire / February 23, 2015 / Leave a comment
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In 2013, the Nobel Prize in Economics was awarded to three men—Robert J Shiller, Eugene F Fama and Lars Peter Hansen—for their “empirical analysis of asset prices”. Where, the award committee noted, Fama’s research had led him to the conclusion that “stock price movements are impossible to predict in the short-term and that new information affects prices almost immediately, which means that the market is efficient,” for Shiller, on the other hand, “stock prices can be predicted over a longer period… In contrast to the dominant perception, stock prices fluctuated much more than corporate dividends. Shiller’s conclusion was therefore that the market is inefficient.”
In his Nobel Prize lecture, Shiller examined the effects that the “behavioural finance revolution,” which saw the insights of psychology and other social sciences imported into economics, had had on the theory of market efficiency developed by Fama and others. “Once we acknowledge that the efficient markets theory has no special claim to priority for price determination”—a conclusion Shiller had reached in his econometric work on market volatility in the 1980s—”we can look more sympathetically to other factors to understand market fluctuations,” he argued.
We can look, for instance, to what Keynes, writing in the 1920s, had called “animal spirits”—”changes that infect the thinking even of most of the so-called smart money in the market.” In 2009, Shiller and the economist George Akerlof borrowed Keynes’s phrase for the title of a book that explored the extent to which psychological factors—confidence, fear, bad faith and so on—shape financial events. That book built on the arguments of an earlier book of Shiller’s, “Irrational Exuberance”, the first edition of which was published in 2000, at the height of the boom in “dot com” stocks in the United States. In the second edition of “Irrational Exuberance,” published in 2005 (in the midst of another asset price boom, this time in house prices), Shiller offered the following definition of a speculative “bubble”: “A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”