Part I
Why Everything You Learned in Business School is Wrong
1
Six Impossible Things before Breakfast, or, How EMH has Damaged our Industry1
The efficient markets hypothesis (EMH) is the financial equivalent of Monty Pythonās Dead Parrot. No matter how much you point out that it is dead, the believers just respond that it is simply resting! I wouldnāt really care if EMH was just some academic artefact, but as Keynes noted, āpractical men are usually the slaves of some defunct economistā. The EMH has left us with a litany of bad ideas, from CAPM to benchmarking, and risk management to shareholder value. The worst of its legacy is the terrible advice it offers on how to outperform - essentially be a better forecaster than everyone else. It is surely time to consign both the EMH and its offshoots to the dustbin of history.
ā¢ Academic theories have a very high degree of path dependence. Once a theory has been accepted it seems to take forever to dislodge it. As Max Planck said, āScience advances one funeral at a timeā. The EMH debate takes on almost religious tones on occasions. At one conference, Gene Fama yelled āGod knows markets are efficient!ā This sounds like a prime example of belief bias to me (a tendency to judge by faith rather than by evidence).
ā¢ The EMH bothers me less as an academic concept (albeit an irrelevant one) than it does as a source of hindrance to sensible investing. EMH has left us with a long list of bad ideas that have influenced our industry. For instance, the capital asset pricing model (CAPM) leads to the separation of alpha and beta, which ends up distracting from the real aim of investment - āMaximum real total returns after taxā as Sir John Templeton put it.
ā¢ This approach has also given rise to the obsession with benchmarking, and indeed a new species, Homo Ovinus - whose only concern is where it stands relative to the rest of the crowd, the living embodiment of Keynesā edict, āThat it is better for reputation to fail conventionally, than succeed unconventionallyā.
ā¢ The EMH also lies at the heart of risk management, option pricing theory, and the dividend and capital structure irrelevance theorems of Modigliani and Miller, and the concept of shareholder value, all of which have inflicted serious damage upon investors. However, the most insidious aspects of the EMH are the advice it offers as to the sources of outperformance. The first is inside information, which is, of course, illegal. The second, is that to outperform you need to forecast the future better than everyone else. This has sent the investment industry on a wild goose chase for decades.
ā¢ The prima facie case against EMH is the existence of bubbles. The investment firm, GMO defines a bubble as at least a two-standard-deviation move from (real) trend. Under EMH, a two-standard-deviation event should occur roughly every 44 years. However, GMO found some 30 plus bubbles since 1925 - that is slightly more than one every three years!
ā¢ The supporters of EMH fall back on what they call their āNuclear Bombā, the failure of active management to outperform the index. However, this is to confuse the absence of evidence with the evidence of absence. Additionally, recent research shows that career risk minimization is the defining characteristic of institutional investment. They donāt even try to outperform!
What follows is the text of a speech to be delivered at the CFA UK conference on āWhatever happened to EMH?ā, dedicated to Peter Bernstein. Peter will be fondly remembered and sadly missed by all who work in investment. Although he and I often ended up on opposite sides of the debates, he was a true gentleman and always a pleasure to discuss ideas with. I am sure Peter would have disagreed with some, much and perhaps all of my speech, but Iām equally sure he would have enjoyed the discussion.
THE DEAD PARROT OF FINANCE
Given that this is the UK division of the CFA I am sure that The Monty Python Dead Parrot Sketch will be familiar to all of you. The EMH is the financial equivalent of the Dead Parrot (Figure 1.1). I feel like the John Cleese character (an exceedingly annoyed customer who recently purchased a parrot) returning to the petshop to berate the owner:
Eās passed on! This parrot is no more! He has ceased to be! āEās expired and gone to meet āis maker. āEās a stiff! Bereft of life, āe rests in peace! If you hadnāt nailed āim to the perch āeād be pushing up the daisies! āIs metabolic processes are now āistory! āEās off the twig! āEās kicked the bucket, āeās shuffled off āis mortal coil, run down the curtain and joined the bleedinā choir invisible!! This is an ex-parrot!!
The shopkeeper (picture Gene Fama if you will) keeps insisting that the parrot is simply resting. Incidentally, the Dead Parrot Sketch takes on even more meaning when you recall Stephen Rossās words that āAll it takes to turn a parrot into a learned financial economist is just one word - arbitrageā.
The EMH supporters have strong similarities with the Jesuit astronomers of the 17th century who desperately wanted to maintain the assumption that the Sun revolved around the Earth. The reason for this desire to protect the maintained hypothesis was simple. If the Sun didnāt revolve around the Earth, then the Bibleās tale of Joshua asking God to make the Sun stand still in the sky was a lie. A bible that lies even once canāt be the inerrant foundation for faith!
The efficient market hypothesis (EMH) has done massive amounts of damage to our industry. But before I explore some errors embedded within the approach and the havoc they have wreaked, I would like to say a few words on why the EMH exists at all.
Academic theories are notoriously subject to path dependence (or hysteresis, if you prefer). Once a theory has been adopted it takes an enormous amount of effort to dislocate it. As Max Planck said, āScience advances one funeral at a time.ā
Figure 1.1 The dead parrot of finance!
Source: SG Global Strategy.
The EMH has been around in one form or another since the Middle Ages (the earliest debate I can find is between St Thomas Aquinas and other monks on the ājustā price to charge for corn, with St Thomas arguing that the ājustā price was the market price). Just imagine we had all grown up in a parallel universe. David Hirschleifer did exactly that: welcome to his world of the Deficient Markets Hypothesis.
A school of sociologists at the University of Chicago is proposing the Deficient Markets Hypothesis - that prices inaccurately reflect all information. A brilliant Stanford psychologist, call him Bill Blunte, invents the Deranged Anticipation and Perception Model (DAPM), in which proxies for market misevaluation are used to predict security returns. Imagine the euphoria when researchers discovered that these mispricing proxies (such as book/market, earnings/price and past returns), and mood indicators (such as amount of sunlight) turned out to be strong predictors of future returns. At this point, it would seem that the Deficient Markets Hypothesis was the best-confirmed theory in social science.
To be sure, dissatisfied practitioners would have complained that it is harder to actually make money than the ivory tower theorists claim. One can even imagine some academic heretics documenting rapid short-term stock market responses to news arrival in event studies, and arguing that security return predictability results from rational premia for bearing risk. Would the old guard surrender easily? Not when they could appeal to intertemporal versions of the DAPM, in which mispricing is only corrected slowly. In such a setting, short window event studies cannot uncover the marketās inefficient response to new information. More generally, given the strong theoretical underpinnings of market inefficiency, the rebels would have an uphill fight.
In finance we seem to have a chronic love affair with elegant theories. Our faculties for critical thinking seem to have been overcome by the seductive power of mathematical beauty. A long long time ago, when I was a young and impressionable lad starting out in my study of economics, I too was enthralled by the bewitching beauty and power of the EMH/rational expectations approach (akin to the Dark Side in Star Wars). However, in practice we should always remember that there are no points for elegance!
My own disillusionment with EMH and the ultra rational Homo Economicus that it rests upon came in my third year of university. I sat on the oversight committee for my degree course as a student representative. At the university I attended it was possible to elect to graduate with a specialism in Business Economics, if you took a prescribed set of courses. The courses necessary to attain this degree were spread over two years. It wasnāt possible to do all the courses in one year, so students needed to stagger their electives. Yet at the beginning of the third year I was horrified to find students coming to me to complain that they hadnāt realized this! These young economists had failed to solve the simplest two-period optimization problem I can imagine! What hope for the rest of the world? Perhaps I am living evidence that finance is like smoking. Ex-smokers always seem to provide the most ardent opposition to anyone lighting up. Perhaps the same thing is true in finance!
THE QUEEN OF HEARTS AND IMPOSSIBLE BELIEFS
Iām quite sure the Queen of Hearts would have made an excellent EMH economist.
Alice laughed: āThereās no use trying,ā she said; āone canāt believe impossible things.ā
I daresay you havenāt had much practice,ā said the Queen. āWhen I was younger, I always did it for half an hour a day. Why, sometimes Iāve believed as many as six impossible things before breakfast.
Lewis Carroll, Alice in Wonderland.
Earlier I alluded to a startling lack of critical thinking in finance. This lack of ālogicā isnāt specific to finance; in general we, as a species, suffer belief bias...