## Friday, December 19, 2008

### "Efficient" doesn't necessarily mean "accurate"

Robert Skidelsky has an interesting article in this week's New York Times Magazine Section on the relevance of John Maynard Keynes in today's economy. However, Skidelsky makes an odd mistake for an economist, stating:
"Greenspan must have believed something like the “efficient-market hypothesis,” which holds that financial markets always price assets correctly. Given that markets are efficient, they would need only the lightest regulation. Government officials who control the money supply have only one task — to keep prices roughly stable."
That's not exactly what the "efficient market hypothesis" says. Rather, the idea is that market prices contain all relevant information about assets, which means that no one can consistently make above-average financial returns. There's a weak form of the argument (prices reflect all past information about the asset) and a strong form (prices reflect all present and future information about the asset). But no matter which form, the argument does not preclude the possibility that the information is wrong. It simply says that all the available information is reflected in the price. Princeton Professor Burton Malkiel, author of A Random Walk Down Wall Street explains:
"...it is important to make clear what I mean by the term “efficiency”. I will use as a definition of efficient financial markets that they do not allow investors to earn above-average returns without accepting above-average risks.

A well-known story tells of a finance professor and a student who come across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, “Don’t bother—if it were really a$100 bill, it wouldn’t be there.” The story well illustrates what financial economists usually mean when they say markets are efficient.

Markets can be efficient in this sense even if they sometimes make errors in valuation, as was certainly true during the 1999-early 2000 internet bubble. Markets can be efficient even if many market participants are quite irrational. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends. Many of us economists who believe in efficiency do so because we view markets as amazingly successful devices for reflecting new information rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn above-average risk-adjusted returns. In short, we believe that \$100 bills are not lying around for the taking, either by the professional or the amateur investor."
Markets are really, really good at aggregating information. However, if the information is bad, then prices will not reflect the "true" value of goods. In computer science terms, markets can be victims of GIGO.

David said...