Does Efficient Market Hypothesis really works?
Fama has shaped many economic theories as we perceive them today. His Efficient Market Hypothesis (EMH) is taught in almost all the universities that teach something related to the economics of markets. Starting from my university education I have read numerous research papers by Fama and EMH is a big milestone indeed. But, to my mind, it’s still not the right theory especially when it comes to justifying the current circumstances.
The efficient-market hypothesis asserts that financial markets are “informationally efficient,” claiming one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis.
But if we have to believe in Fama’s EMH that would mean all the legendary investors wouldn’t exist because they wouldn’t have any opportunity to profit from the random behaviour of the markets, but, on contrary, they do exist.
There can be consistent profit making in the markets and there are more the enough instances to prove that it is not just by chance that good investors make consistent profits over the years in the long run.
Fama is the economist in the old joke who sees a hundred-dollar bill on the ground but doesn’t pick it up. “Why didn’t you pick it up?” a friend asks. The economist replies, “It’s impossible—a hundred-dollar bill would have already been picked up by now.”
Fama is not just a Nobel laureate. He also co-authored the textbook, The Theory of Finance, with another Nobel winner, Merton H. Miller. He won the 2005 Deutsche Bank Prize in Financial Economics as well as the 2008 Morgan Stanley-American Finance Association Award. He is seriously a big deal in the economics world.
The New Yorker‘s John Cassidy asked Fama how he thought the efficient-market hypothesis had held up during the recent financial crisis. The new Nobel laureate responded:
“I think it did quite well in this episode. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. There was nothing unusual about that. That was exactly what you would expect if markets were efficient.”
When Cassidy mentioned the credit bubble that led to the housing bubble and ultimate bust, the famed professor said:
“I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
Well, I and much more like me can very easily say that they have seen housing and credit bubbles, and I don’t see any reason why they would say that bubbles didn’t happen. How can you just don’t think they happened and caused the biggest financial crisis of our times.
Bubbles do exist and markets are more often priced wrongly and that’s why they tend to correct themselves giving opportunities to profit from the movement.