My colleague Barry Ritholtz recently sat down to talk with Burton Malkiel — of A Random Walk Down Wall Street fame — on his Masters in Business podcast. Right off the bat Malkiel did some myth-busting on the Efficient Market Hypothesis:
What efficient markets are associated with which is wrong is that efficient markets mean that the price is always right – that the price is exactly the present value of all of the dividends and the earnings that are gonna come in the future and the price is perfectly right. That’s wrong. The price is never right. In fact, prices are always wrong. What’s right is that nobody knows for sure whether they’re too high or too low. It’s not that the prices are always right, it’s that it’s never clear that they are wrong…the market is very, very difficult to beat.
Anytime there’s a crazy move up or down in individual securities or the markets in general a large group of investors will comment on the fact that it’s laughable to assume that markets are efficient. And it would be silly for anyone to believe that the markets are perfectly efficient. But as Meir Statman once said, “The market may be crazy, but that doesn’t make you a psychologist.”
Because of the Internet nothing is properly rated these days anymore. Like the markets themselves, everything is in a constant state of being over- or under-rated. Academic finance theories are no different.
In the 70s, 80s and 90s academic theories were accepted by far too many investors as fact without understanding their real world implications. Textbooks rarely translate perfectly into the real world because there’s always the human element to consider and you can’t really create a formula to account for human nature. The behavioral side of the markets was under-appreciated.
In recent years, many of the original academic theories have come under attack because of this. While I agree that there’s a huge difference between theory and application, I still think academic finance theories can be useful as a starting point for your baseline assumptions.
For example, Harry Markowitz’s modern portfolio theory isn’t perfect because the correlations and variances between different asset classes and securities are constantly changing and evolving over time. But the baseline assumption that risk and reward are related and that diversification is a worthwhile endeavor is still a useful starting point that his theories brought to light.
The late Peter Bernstein talked about some of the most well-known academic theories in his book Capital Ideas Evolving and I thought he really nailed the implications here:
Before Harry Markowitz’s 1952 essay on portfolio selection, there was no genuine theory of portfolio construction — there were just rules of thumb and folklore. It was Markowitz who first made risk the centerpiece of portfolio management by focusing on what investing is all about: investing is a bet on an unknown future. Before Bill Sharpe’s articulation of the Capital Asset Pricing Model in 1964, there was no genuine theory of asset pricing in which risk plays a pivotal role — there were just rules of thumb and folklore. Before Franco Modigliani and Merton Miller’s work in 1958, there was no genuine theory of corporate finance and no understanding of what “equilibrium” means in financial markets — there were just rules of thumb and folklore. Before Eugene Fama set forth the principles of the Efficient Market Hypothesis in 1965, there was no theory to explain why the market is so hard to beat. There was not even recognition that such a possibility might exist. Before Fischer Black, Myron Scholes, and Robert Merton confronted both the valuation and the essential nature of derivative securities in the early 1970s, there was no theory of option pricing — there were just rules of thumb and folklore.
The academic creators of these models were not taken by surprise by difficulties with empirical testing. The underlying assumptions are artificial in many instances, which means their straightforward application to the solution of real-time investment problems is often impossible. The academics knew as well as anyone that the real world is different from what they were defining. But they were in search of a deeper and more systematic understanding of how markets work, of how investors interact with one another, and of the dominant role of risk in the whole process of investing. They were well aware that their theories were not a finished work. They were building a jumping-off point, a beginning of exploration, and, as each step led to the next, they began to search for an integrated structure to simultaneously explain the performance of markets and to solve the investor’s dilemma in trading off risk against return. That structure is still evolving.
My first thought when reading Bernstein’s take here is just how young investment theory really is in the grand scheme of things. Investors were basically in the Dark Ages until 4-5 decades ago and as he says — things are still evolving.
I don’t think enough investment professionals today appreciate the contributions made by academics in the investment management profession. Far too many investors spend their time criticizing these theories because they don’t provide a perfect roadmap or explanation of the inner workings of the financial markets.
The reality is that there is no such thing as a theory or formula that is going to be able to explain why markets or investments do what they do all the time. That would be impossible.
They’re not perfect, but they can still be utilized as the building blocks or baseline assumptions before applying your own thoughts and ideas to the markets or your specific strategies. What you do with that is up to you.
Listen to the entire podcast between Barry and Malkiel here:
Burton Malkiel’s Random Walk (Bloomberg)
Capital Ideas Evolving
The Biggest Difference Between the Real World and Academia