Controversy over efficiency of share markets

A reader of the previous week’s My View on ‘Playing the Share Market Game: Play it according to Rules’ has taken issue with economists for not using mathematics to present their ideas precisely and failing to come up with theories acceptable to everyone alike.

As a result of this second implication, he has claimed that economic theories presented by one economist are subject to dispute by others and therefore, economics has become a subject without a consensus.

Economists may not be sound advisors

The criticism of this reader is valid in the sense that the observed absence of consensus among economists leads to confusion rather than enrichment of knowledge. Economists taking two different views at two different times or giving vague answers like ‘on the one hand, this can happen and on the other, this can happen’ have frustrated most of the pragmatic politicians who need quick fixes to issues.

Therefore, the angry US President Harry S Truman is reported to have demanded a ‘one handed economist’ according to the book of quotations (available at http://quotationsbook.com/quote/11809/).

The way economists form their theories too has been subject to criticism by cynical politicians: as reported by Charles Wheelan in his ‘naked economics’, the US President Ronald Reagan is reported to have described economists as people who see something in practice and then wonder whether it would work in theory too, a process similar to putting the cart before the horse. They are also accused of being too much dogmatic and theoretical.

A joke that has widely circulated has the following story about economists: two economists walking down the street see a $ 100 bill in a gutter and one wonders whether it is a 100 dollar bill and the other quickly dismisses his speculation saying that if it were a 100 dollar bill, it would have been picked up by someone already.

What it means is that, according to economists, people are all rational and rational people will quickly exploit profit opportunities and not leave a valuable asset unused. It also explains why economists are poor; they can advise others how to make money but they themselves are not good at picking up profitable opportunities.

So, according to many, economists are not the best people who can give sound advice to others.

Limitation of mathematics in presenting the real world

The criticism levelled against economists on the ground of not using mathematics for formulating economic theories is not exactly correct. Economists like Kautilya in the 4th century BCE or later day economists like Adam Smith in the 18th century CE did not use mathematical equations to explain their economic logic, but more modern economists, from the time of Yale University academic Irwin Fisher who published ‘The Nature of Capital and Income’ in 1906 and later ‘The Theory of Interest’ in 1930, started to use mathematics extensively to present their economic logic more cogently.

Following Fisher’s tradition, many of the economists who presented theories of investment in the first half of the last century were all mathematically and statistically inclined academics. For instance, Austria-born Oskar Morgenstern and Hungary-born John von Neumann solidified the rational behaviour of investors in maximising their return through the maximisation of an expected utility in an equation filled publication titled ‘Theory of Games and Economic Behaviour’ in 1944.

However, it was left to the Massachusetts Institute of Technology economist Paul Samuelson to incorporate mathematical logic to economics in 1947 by rewriting his doctoral dissertation ‘Foundations of Economic Analysis’ in mathematical form. Since then, mathematics came to stay permanently with economics; any economic theory or paper which did not use mathematics was simply ignored by mainstream economists.

However, mathematics has its own limitation of explaining the real world which we live in. Mathematical logic which is also called Aristotelian Dualistic Logic could explain only two events, namely, ‘yes-no’ or ‘true-false’. This meant that an equation could have a solution or it cannot have a solution; there is no any intermediary state of events. In contrast to this two-dimensional world, the real world is multi-dimensional and hence, cannot be properly explained by simply using mathematical logic.

To explain the real world, it is necessary to use a logical system like ‘fuzzy logic’. Taking this limitation into account, the writer recalls that a professor at Simon Fraser University in Canada, a great mathematician himself, used to print the following restriction in his question papers on Advanced Microeconomics: ‘answer this paper without using mathematics or technical terms’. He believed that, when properly used, words had a greater power in conveying human ideas clearly to others.

Economists should necessarily disagree with each other

Now, about economists disagreeing with each other. This may seem a grave crime, but one should understand that the purpose of scientific inquiry is to find ‘a truth’ rather than ‘the truth’. Hence, a truth that is established with overwhelmingly supportive evidence today is liable to be refuted tomorrow thereby paving the way for establishing ‘another new truth’, again until it is refuted by another scientist. This feature of scientific inquiry distinguishes it from myths and has been responsible for developing human knowledge throughout history.

Thus, the London School of Economics based philosopher Karl Popper announced that ‘refutability’ of the established scientific theories is the main feature attributable to a scientific theory. If a theory cannot be refuted, then, it is not science but something like ‘an absolute truth’. Therefore, disagreement among economists, or for that matter among intellectuals in any other branch of science, is not something about which people should be worried. It is a healthy feature which is necessary for the advancement of science.

Accordingly, economic theories that have been developed to explain the operation of share markets too have been subject to debate and dispute. Instead of having a consensus, there is much controversy surrounding the behaviour of share markets as propounded by different schools of economists.

One school of economists known as the efficient market school believe that the share markets are efficient and behave perfectly in a random manner so that its future events cannot be predicted with certainty. The other school called the behavioural finance school refutes this claim.

The efficient market school

The efficient market school comes from the mainstream economics that has many convenient assumptions about the behaviour of markets and its participants. Accordingly, the market participants are rational, try to get the maximum gain for them, search for information and make carefully considered economic decisions.

The rational people have several qualities: they are always consistent in the sense that if they make a decision today, they would not change it tomorrow unless they have compelling evidence to the contrary; before making a decision, they assess both the costs and benefits of such decision carefully and make the decision only if the benefits overwhelms the costs; to do so, they acquire all the necessary and relevant information and assess that information carefully; thus, they develop a skill called ‘perfect foresight’ so that the future events are not uncertain; by behaving in this manner, they are not guided by emotions and cannot be fooled by crafty and smart people.

When decisions are made in this manner, the demand for shares is guided purely by an accurate assessment of the markets today and tomorrow. Thus, share market prices reflect all the relevant information that has been made available to the prospective investors.

A theory should be valued by its predictive power

One criticism made against this model is that the assumptions made are totally unrealistic and therefore, an economic theory developed on the basis of unrealistic assumptions is not valid. This is a fair criticism but then, if one goes by it, it challenges the whole scientific world.

This is because the real world is so complex and for a scientist to map the real world, he should necessarily make simplifying assumptions about the real world. In the choice of his assumptions, he has to take into account only the most important features of the real world and leave out many which are not so important for his main purpose.

As we mentioned earlier, the purpose of science is not to find the truth, but a truth which amply explains the real world. Hence, if the assumptions help him to attain his main objective, then, that is sufficient for him to come up with a theory that would reasonably explain the real world.

When this criticism was made against economic theories in 1940s, mainly by an economic school called institutionalists, it was the Chicago University economist Milton Friedman who answered them.

In a paper he published in 1953, under the title ‘The Methodology of Positive Economics’, he asked the question ‘so what?’ If a theory is good enough to make fair predictions about the future, then, one should not be worried about the underlying mechanism of building that theory.

A good analogy is as follows: it does not matter whether it is a small man inside the television set that gives us the picture and sound when we switch on the television set. What matters to us is whether the TV set gives us the picture and sound.

So, according to Friedman, the process by which a theory has been made may be a complete black box, incomprehensible and unknown to the person who uses the theory. For him, if the theory helps him to make accurate predictions, then, that is a sign of a good theory. So, a theory is valued from its practical usefulness and not by the realistic nature of its assumptions. This approach to science is called pragmatism.

 

Three off-shoots of efficient markets

Based on these arguments, three separate and independent off-shoots about efficient markets have been developed. The first is that the share markets display a random behaviour which economists call the random walk hypothesis, an analogy drawn from the unpredictable walk of a drunkard.

Since no one could predict accurately where a drunkard would place his foot next, so is it difficult to predict how the market prices would change in the next period. Though many past economists and statisticians had discovered this random nature of the change in share market prices, the credit for presenting it in a formal way goes to Paul Samuelson and a team of economists who worked under him in early 1950s.

The second off-shoot of the investment theory came from two economists, Ando Modigliani and Merton Miller who published two papers during a short span of three years during 1958 to 1961. Their approach known as Modigliani and Miller or M & M Approach presented a revolutionary idea about firms’ investment decisions.

According to them, it did not matter in what form a firm raised its funds, whether by issuing shares, bonds or using internal reserves. What mattered was whether the investment made would raise the value of the firm’s shares. If it did so, it was worth undertaking the said investment. If not, it was not worth considering the investment.

A practical problem with their approach is that a firm has to know in advance how the share market would react to its investment decisions in order to assess whether a given investment is desirable or not. Modigliani and Miller did not give a satisfactory answer to this question.

Efficient market hypothesis and its revisions

The third off-shoot was developed by the Chicago University economist Eugene Fama who published two papers in 1965, one titled ‘The Behaviour of Stock Market Prices’ and the other titled ‘Random Walks in Stock Prices’ based on his 1964 PhD dissertation submitted to the Chicago Business School. His research and publications gave birth to the now famous Efficient Market Hypothesis or EMH.

Fama argued that markets are informationally efficient and any new information released to the market would spontaneously adjust the market prices. Because of this feature in markets, no one would be able to consistently achieve super gains in the markets since information which is available to one investor is available to others as well. This is because rational investors always looked for relevant information and made use of such information in making investment decisions.

When the critics pointed out that market participants are not rational, Fama subsequently revised his EMH presenting three types of market efficiency: a weak form efficiency in which stock prices reflect all the past information, a semi-weak form in which the prices reflect all the publicly available information and a strong form in which the stock prices reflect even the publicly unavailable exclusive private information. Thus, according to this strong form, no one can earn super gains through insider trading.

 

Behaviouralists’ attack on efficient markets

The main challenge to this efficient market school came from the behavioural finance school. Led by the Carnegie Mellon University economist Herbert Simon, this school challenged the main premise of the efficient market school, namely, that the market participants are rational.

Herbert Simon found that people are not that rational due to three impediments. First, they have no access to all the relevant information. Second, even if they have access to information, their brain power is not adequate to process that information accurately. Third, they have no time to sit back and process that information. Hence, their rationality is bounded by these three impediments and Simon called it ‘bounded rationality’.

Since people are far from being rational, they do not maximise their gains. They simply try to satisfy their desires sufficiently and Simon coined the word ‘satisfice’ to describe this behaviour combining the two words ‘satisfy’ and ‘suffice’. Hence, according to behavioural financiers, people are not maximisers but satisficers.

Prospect theory

Two psychologists, Daniel Kahneman and Amos Tversky built on Simon’s findings on limited rationality of people. In a paper they published in Econometrica in 1979, they presented their new approach as ‘Prospect Theory’ which argued that the evaluation of risky outcomes by people is often distorted because of four factors.

First, people do not seek correct information but information to endorse their beliefs. Second, people do not have the full picture of a situation and base their judgments on the very little they know about it. Third, they always attach an unnecessarily high value to small and unimportant events. Fourth, in the presence of potential gains, they become risk-averse and in the face of losses, they become risk-seeking.

Accordingly, a typical person would make more losses when the prices are falling or when there is a bearish market. In contrast, they make more gains when the prices are rising or when there is a bullish market. In terms of the prospect theory, people have a tendency to display a herd behaviour which is denied by the efficient market school.

The behaviour of the participants in actual share markets is close to what the behavioural financiers have explained. The market participants are irrational and can be led like a herd by a market manipulator. It enables some people to earn super profits at the expense of less informed investors who simply function as the exit mechanism for the crafty market manipulators. In many countries, the state run investment funds fall into this category of less informed investors.

(W.A. Wijewardena can be reached at [email protected].)