August 12, 2009
Richard Thaler, the researcher whose work has brought such key behavioral finance issues as myopic loss aversion to light, says recent events have shown markets are not efficient, but that they are still the best way to employ capital.
“Counting the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory,” Thaler wrote in The Financial Times. “They led to misallocations of resources measured in the trillions and … the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be ‘right’, then these bubbles would not occur. … [But] while imperfect, financial markets are still the best way to allocate capital.”
Thaler says that because prices are inefficient, governments could take steps to help stabilize markets. Among them: linking the down-payment for mortgages to a measure of real estate “frothiness”, and ensuring that bank reserve requirements “are set dynamically according to market conditions”.
Thaler also offers a good summary of the history of efficient market hypothesis and its impact on modern financial theory. And he makes some interesting observations about the nature of bubbles, and trying to predict them. For example, even knowing that a bubble is happening doesn’t mean you can profit from it, he says: “Lunches are still not free. Shorting internet stocks or Las Vegas real estate two years before the peak was a good recipe for bankruptcy, and no one has yet found a way to predict the end of a bubble.”
I went to Chicago Graduate School of Business more a decade ago. Without much prior knowledge about the market, I was taught the EMH as if it was given from God. Ever since then, through investing myself and a lot more reading, I have started to doubt the truth of EMH. In addition to what Professor Thaler said in this article, I can not understand how EMH can explain that there is a group of value investors (Warren Buffet as the famed example) can consistently beat the market over the long term. It is true that many famed value investors lost big time in this recent financial crisis, adding to the argument that the market is unpredictable and hard to beat. But it is hard to agree with the statement that the price is always right, given the bubble forming and bursting.
But I have to say that every day all these great value investors are working hard to make the market closer to be efficient, as they keep buying the undervalued assets and eventually the price of the assets meets the value. So EMH practioners still have someting to hang on to.