Academic journal article Washington and Lee Law Review

Efficient Market Theory: Let the Punishment Fit the Crime

Academic journal article Washington and Lee Law Review

Efficient Market Theory: Let the Punishment Fit the Crime

Article excerpt

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.(1) Beajamin Graham

In the 1980s some things went right on Wall Street but much went wrong. The fallout is still being felt today. Prudential Securities, which for years boasted that "the most important thing we earn is your trust," now apologizes for having systematically duped many of the hundreds of thousands of investors who bought its limited partnership deals. Carl Icahn boasted of having bought TWA, but leaving none of his own money there, he succeeded only in leaving the flying public with twenty year-old aircraft and poor service. Banks and insurance companies bankrolled so many new buildings that we will not work off the excess until the end of the century, if then. As we close the books on the worst era in modern U.S. financial history, Prudential at least has the resources to make amends. Those victimized by others must often grasp at straws.

This is a good time for a post-mortem. It is not widely recognized, but scholars played an important role in the debacle, providing ingenious free-market theories to justify some of the worst excesses. One such concept, efficient market theory, contributed to the damage then and, in its various mutations, continues to do so today.

Even if you are not a student of financial economics, the phrase "efficient market theory" sounds right. After all, the stock market is crudely efficient: markets set the minute-to-minute value of stocks, the spreads between bid and asked prices are very small, and commissions are as little as two cents a share.

Efficient Market Theory (EMT), however, posits something more radical. The principal version, and the one on which this indictment will focus, states that we can trust the pricing of stocks. Supposedly, competition among sophisticated investors enables the stock market to price stocks "accurately "--that is, in accordance with our best expectations of companies' long-term prospects. (The trading by nonprofessionals is said to be random and of no net effect.) Supposedly, too, all relevant publicly available information is analyzed by investors, and new data, such as releases, are quickly noted, digested, and then reflected in the share prices.

In short, stock prices, while not perfect, are as perfect as,can be. There are no better estimates of the fundamental value of a company and no systems for beating the market. A corollary is that the wisest of us can do no better than to buy the market as a whole; the rest of us can do far worse.

EMT rests on several quite controversial assumptions, the most striking of which is the terribly convenient but circular assumption that mispriced stocks cannot long exist because if they did, "smart money" investors/arbitrageurs would already have eliminated them. This when-all-else-fails assumption, so central to the theory, is also the source of the well-worn joke about two economists walking across the campus who spy what seems to be a twenty dollar bill. As the younger economist leans forward to examine it, her older colleague restrains her. "If it really were a twenty dollar bill," he says, "someone would already have picked it up."(2)

Given the assumption that patience and intelligence are of no consequence, even a super-investor like Warren Buffett should not be able, certainly not with any consistency, to find loose money lying on the table. In fact, it would be a waste of his time to look.

As one of the high priests of EMT recently wrote, with visible pride, the testing of the theory has itself become so voluminous as to be a "research industry," and a mature one at that.(3) I do not intend to go over that voluminous, often dreary body of data. Much of it focuses on such trivialities as the January effect--small company stocks are said to do better in January--or how quickly the market responds to news of, say, a stock split or dividend increase. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed


An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.