IF YOU MEET THE RATIONAL ACTOR IN THE ROAD KILL HIM:

Are We All Behaviorists Now? (Stephen Bainbridge, 10/20/2004, Tech Central Station)

The [efficient capital markets hypothesis]'s fundamental thesis is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. As applied to stock markets, the ECMH thus has two principal implications. First, stock prices follow a random walk. Put another way, the ECMH predicts that price changes in securities are random. Randomness does not mean that the stock market is like throwing darts at a dart board. Stock prices do go up on good news and down on bad news. Randomness simply means that stock price movements are serially independent: future changes in price are independent of past changes. In other words, investors can not profit by using past prices to predict future prices.

Second, the ECMH posits that current prices incorporate not only all historical information but also all current public information. This form predicts that investors can not expect to profit from studying publicly available information about particular firms because the market almost instantaneously incorporates information into the price of the firm's stock.

The ECMH assumes investors are rational actors whose behavior is consistent with that predicted by the rational choice model. Over the last decade or so, behavioral economists (such as Thaler) have drawn on experimental economics and cognitive psychology to identify systematic departures from rational decisionmaking, even in market settings. Put another way, behavioral economics claims that humans tend to make decisions in ways that systematically depart from the predictions of rational choice. [...]

There is considerable evidence that markets adapt to investor irrationality over time. If investor irrationality produces pricing errors, it becomes possible to profit by taking advantage of them. At one time, for example, the capital markets showed a systematic bias against small cap firms. As a result, it was possible to earn abnormal returns by investing in a portfolio weighted towards small caps. Over time, many investors did so, including a substantial number of mutual funds that specialized in small cap investing. As a result, the small cap anomaly gradually faded to the point at which it was no longer possible to systematically beat the market by investing in them. We have observed much the same with respect to other anomalies. Hence, there is considerable evidence that experienced traders can learn their way out of the irrational behavior patterns that lie at the bottom of so many market anomalies.

Accordingly, while the ECMH may not be perfect, it still probably does a better job of predicting market behavior over time than any of the behavioral theories.

Note that Professor Bainbridge works some sleight of hand here: he goes from the ECMH talking about "current pricing" being accurate to the ECMH being vindicated because over long enough periods of time the inaccuracy of every given moment may produce corrective effects.

As all human institutions, markets are irrational and inefficient, but they do seem, as Mr. Bainbridge says, more efficient than the alternatives. That's as much as Man can hope to achieve.

Posted by Orrin Judd at October 20, 2004 04:11 PM