Warren Buffett said most of what you need to know about efficient markets. “Observing correctly that the market was frequently efficient, they [academics, investment professionals and corporate managers] went on to conclude incorrectly that it was always efficient. The difference between the propositions is night and day.”
Mr Buffett has made his money not from the part that is frequently efficient, but from the part that is infrequently inefficient.
The efficient market hypothesis has been the bedrock of financial economics for almost 50 years. Market efficiency is a hypothesis about the way markets react to information and does not necessarily imply that markets promote economic efficiency in a wider sense. But there is a relationship between the two concepts of efficiency.
There are three versions of the efficient market hypothesis. The strong version claims that everything you might know about the value of securities is “in the price”. It is closely bound up with the idea of rational expectations, whose implications have dominated macroeconomics for 30 years. Policy interventions are mostly futile, monetary policy should follow simple rigid rules, market prices are a considered reflection of fundamental values and there can be no such things as asset-price bubbles.
These claims are not just empirically false but contain inherent contradictions. If prices reflect all available information, why would anyone trouble to obtain the information they reflect? If markets are informationally efficient, why is there so much trade between people who take different views of the same future? If the theory were true, the activities it purports to explain would barely exist.
Economic models are illustrations and metaphors, and cannot be comprehensive descriptions even of the part of the world they describe. There is plenty to be learnt from the theory if you do not take it too seriously – and, like Mr Buffett, focus on the infrequent inefficiency rather than the frequent efficiency.
The weak efficient market theory tells us that past prices are no guide to what will happen to security prices in future. There is a good deal of evidence for this claim: you would be as well employed studying the patterns on your palm as patterns on charts. But there is also evidence of a tendency for short-term price movements to continue in the same direction – momentum is real. If you know precisely when the short term becomes the long term, this would make you very rich. It is possible to make money – or policy – through reading boom-and-bust cycles. But most participants do not.
The semi-strong version of the theory claims that markets reflect all publicly available information about securities. What is general knowledge will be in the price. But inside information, or original analysis, might add value.
The strong version of the efficient market hypothesis is popular because the world it describes is free of extraneous social, political and cultural influences. Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies.
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