Irrational seducers – why the EMH has had such a hard time.

Like every other area of the social sciences financial hypotheses do not explain all the facts. So it is with the Efficient Market Hypothesis. The EMH is not a perfect explanatory hypothesis. However, its failures are so unpredictable that it is hard to see what alternative there might be in shaping the choices investors might make. Do we assume that the EMH is false and abandon the financial models that depend upon it: the net present value rule, the theory of capital asset pricing, option pricing and all the rest? At their heart all these theoretical structures make an assumption that individuals and markets, at their core, behave with some rational purpose. What Mark Rubinstein defines as ‘minimally rational markets’. Or do we succumb to the seduction of irrationality? The idea that because some alternative appears to have higher explanatory power that it is, necessarily, a better guide to future action. If any single investor group could unequivocally demonstrate that they had the modern equivalent of the philosopher’s stone then I would be more sympathetic to the notion that the EMH – or to be more precise the rational expectations framework upon which it is based – has had its day. But there is precious little evidence that is the case.
As you can probably infer I am not a great fan of the reductionists’ behavioural critique of the EMH preferring the more emergent perspective the hypothesis implies. Indeed the absence of convincing evidence that any replicable investment strategy can out-perform the market leads me to the inescapable conclusion that such a strategy does not exist. A slightly weaker proposition is that there does not appear to be any single investor group, fund managers, private investors or computer programmers, who can consistently earn an excess return once properly controlled for risk. It is over 10 years since Mark Carhart’s (1997) powerful replication of Michael Jensen’s landmark 1969 paper demonstrated that no single class of fund manager had outperformed, in their stock selection, a monkey lobbing a dart at the Financial Times or the Wall Street Journal. The persistence in performance demonstrated by the occasional ‘winners’ could be explained by the persistence derived from the weak persistence of share prices rather than anything attributable to the skill of the respective fund manager.

I remember when Jensen’s 1969 study of mutual funds almost single-handedly convinced me that large cap equity markets were for practical purposes at least minimally rational... Now, 30 years later, the evidence is even stronger than it was in 1969. The continuing performance of these funds as well as the broad consensus of the substantial research into this issue that has occurred since lend further support to Jensen’s results. This is a step on which those that advocate irrational markets must fall down or else o’erleap for in their way it lies. It should not simply be put on one side of the ledger and given equal weight as any market anomaly on the other side. In fact, piling on the metaphors, the behavioralists have nothing in their arsenal to match it; it is a nuclear bomb against their puny rifles.Mark Rubinstein, Rational Markets: Yes or No? The Affirmative Case Financial Analysts Journal, Vol. 57, No. 3, May/June 2001

It is a sad fact that in the game of equity investment and in the ‘industries’ that support it: financial analysis, forecasting and valuation, monkeys appear to be better at the job than the City’s finest brains. Potential employers might consider this when employing equity analysts. Monkeys by and large do not need fast cars, smart offices and prefer bananas to bonuses.
So how have EMH ‘sceptics’ – the apostles of irrationality - gained such traction? Well, in my view it is because there are dark forces who when they first heard of the EMH were determined to bring it down. It is worth remembering that the EMH in its modern form was driven by the academic community and in particular by the intellectual energy of the University of Chicago. Relatively untainted by special interest the founding fathers of modern finance were prepared to lob a ‘nuclear bomb’ at Wall Street. But be in no doubt, if the EMH was sustained the emperors of Wall Street would be as bare as when they were first borne. So it was a game of survival – the continuation of the high fee, high rolling world of finance meant that this academic research had to be nailed. Fight fire with fire and so huge grants were given to any academic willing to take the devil’s dollar and come up with some anomalous evidence of the EMH. In some respects it was a turkey shoot. Unlike the world of physics and the other natural sciences in the social sciences it is easy to come up with refuting evidence. But even with all of their efforts they still cannot identify a strategy that produces superior investment returns. I know, I keep looking.

Carhart Mark M. (1997) On Persistence in Mutual Fund Performance, The Journal of Finance, Vol. 52, No. 1. (Mar., 1997), pp. 57-82.
Jensen, M. 1968. “The Performance of Mutual Funds in the Period 1945–1964.” Journal of Finance, vol. 23, no. 2 (May):389–416.
———. 1969. “Risk, the Pricing of Capital Assets, and the Evaluation of Investment Portfolios.” Journal of Business, vol. 42, no. 2 (April):167–247.