Investors could be forgiven if they were left scratching their heads over the Nobel Committee's decision to have both a famous advocate and a famous skeptic of efficient markets share the economics prize this year.
In fact, the decision to recognize both Eugene Fama, developer of the efficient market hypothesis, and Robert Shiller, one of EMH's most notable critics, reflects a growing, nuanced consensus about what “market efficiency” means — and doesn't mean — for investors. (University of Chicago economist Lars Hansen also shares in this year's $1.2 million Nobel Memorial Prize in Economic Sciences, but his excellent work is not explicitly about EMH.)
The postulation of an efficient market has been misconstrued to imply a wide variety of things, from the belief that investors should hold stocks for the long run to predictions that stock returns should be normally distributed. Ask Mr. Fama, however, and he will tell you that “market efficiency” is “the simple statement that security prices fully reflect all available information.”
Fair enough, but what does it mean for prices to fully reflect information? To answer that question, you need a model of how markets set prices: Do you rely on earnings per share? The ratio of share price to book value? Twitter traffic on the company's latest product or service? To make any useful assessment of market efficiency, you also need to make some assertion of how the market should reflect information. In other words, you need a security pricing model.
With such a model of efficiency and a particular asset pricing model you can make predictions that you can actually observe and test. But it's always a joint hypothesis, and when it's rejected it can be impossible to determine what caused the rejection. In the narrow circles that care about such things, this is famously referred to as the joint hypothesis problem. You cannot reach a definitive conclusion about market efficiency alone; you can only make statements about the couplet of market efficiency and some pricing model.
This complication, among others, makes it difficult for either the efficient-market camp or the inefficient-market camp to offer a definitive conclusion on market efficiency. With that said, my academic and professional experience has led me to believe that financial markets can be driven by a mix of rational and behavioral forces.
Researchers looking for a clean answer don't tend to love this idea. Many want to be the declarers of a clear winner (and possibly become the next economist to harvest a Nobel for work on EMH). But the real world does not exist to make financial researchers happy.
If markets are somewhere in between perfectly efficient and grossly inefficient what should investors do? In our article “The Great Divide over Market Efficiency,” John Liew and I argue that most investors would be better off acting as if the market were perfectly efficient than acting as though it were easily beatable.
I believe that EMH has contributed more to our understanding of finance and even general economics than any other single idea we can think of in the past 50 years. One way to assess the impact of this idea is to ask whether we know more as a result of the introduction and testing of, and the debate about, the efficient market hypothesis. Most certainly we do. The study of EMH has made our thinking far more precise.
It's hard to remember what finance was like before EMH, but it was not a science; it was barely even abstract art. Markets might not be perfect, but before EMH they were thought to be wildly inefficient. At a minimum, index funds and the general focus on cost and diversification are perhaps the most direct practical offspring of EMH (though perhaps developed independently as Vanguard founder Jack Bogle has admonished me and I have apologetically agreed, the two still were part of a successful movement that implied the same change at about the same time). Simply put, we'd have nothing without EMH. It is our North Star even if we often or always veer 15 degrees left or right of it. But despite this incredible importance, the idea that markets are literally perfect is extreme and silly, and thankfully (at least for us), there's plenty of room to prosper in the middle.
This article was adapted from remarks on May 7 by Cliff Asness, the co-founder, managing principal and chief investment officer of AQR Capital Management, before the CFA Institute Annual Conference in Seattle.