NewsClippingsOnEfficiency

NewsClippingsOnEfficiency - ma €m¥x§s§ ammbeg was: 20%...

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Mag mfi “mac 333 am S E83 Mia mmgwmvfi Efi 3,53 mg?“ 5455 3% w E magnifies mm“ g S & .Hfiwfl _ .maw an S Ems a dump“ mam Eon” E 35% 49% “Morgans .fi {mam E 3&3 a E é «Q i The Economist, February 12th, 2000 Henry Hindsight EMEMBER Felicity Foresight? in our Christmas issue (December 18th) we told the tale of how this little known—but brilliant—lady had used her clever invest— ment strategy to become the world’s rich- est person. Her secret? Perfect foresight. Starting with $1 on January ist 1900, she would predict at the beginning of each year the asset, in any established market in the world, that would experience the highest total dollar return (income plus capital gain) over the following 12 months. She would then put all her wealth in that asset and not touch it for a year. By her 100th year Ms Foresight had turned her initial $1 into $9.6 quintillion (ie, $96 fol— lowed by 17 noughts). Even after deduct— ing taxes and dealing costs, she would still be worth $1.3 quadrillion (a mere :4 4 noughtsl-making her 15,000 times richer than Bill Gates. However, many readers have been asking us the same question: how much would Miss Foresight now be worth if she had instead invested each january in the previous year‘s best-performing asset? Meet Henry Hindsight, an old flame of Fe— licity’s giddy youth. Unlike Felicity, with her annoying trait of infallibility, Henry is more like the typical investor, who tends to follow fash— ion. He buys shares in Asia, say, for the very reason that they have recently risen sharply. Thus whereas Felicity invested in Poland in 1993, enjoying a 754% gain, Henry piled in the next year, only to suffer a 55% decline. All too often, last year’s high flier turned out to be this year’s tunnel- dweller. During the past so years, he suf— fered a loss, on average, every other year. These were offset by one or two spec- tacular gains, but over the 100 years as a whole, his initial $1 stake grew to only $783. Deducting dealing costs, this falls to $290. No wonder Felicity refused to marry poor Henry. One of the best of all her predic— tions was that the marriage would never work. Henry was last seen investing his lit- tle sum in Internet shares. WW illilil we GRE'a’CfiEfi i’xfififiEEE‘iSQN _ I Appivmg a To News KANE. heaven for rising earnings. Still recovering from the mid-April meltdown in stock prices, invesrors breathed that collective sigh of relief lat week. As a flood of quarterly earnings re- ports poured from American corporations —- most of them showing enviable growth —- the major indexes bounced back. The Nas— daq rose 9.7 percent for the week, while the Dow Jones industrials jumped 5.2 percent. Strong earnings-from bellwethers like chase Manhattan, Texas Instruments, Citi- group and America Online were much-need- ed-comfort for investors reassessing their appetite for the newly apparent risks in stocks. ‘ . With many equity strategists reiterating their belief that the companies in the Stand- ard 8: Poor’s 508 will earn 20 percent more this year, on average, than they did in 1999, mirestors regained some confidence that stocks would again produce the double-digit gains they have come to love. ' While this seems an admirably sensible approach —-— how qua'nt to base an invest- ment decision on something real, like a stock’s earnings! — it may not produce the results that investors want. Market history teaches the: when earnings growth is hot~ test, gains in stocks are disappointingly cool. ‘ - Statisticians at Ned Davis Research, an . investment firm in Venice, Fla, have gone back to 1927, studying how stud: prices have reacted to earnings increases and declines. acre are theirfindings: During periods when earnings growth in the 5.8; P. 500 stocks exceeded 20 percent, as isexpected this year, the index has histori- cally. gained an average of 1.2 percent. When earnings have risen ll) percent to 20 percent, the 3.2.: P. has typically risen 6.2 percent. The real gains for stocks come when cor- porate earnings growth is slow or nonexist- ent Re 5.3: P. 500 gained 9.7 percent, on av- erage, during periods when earnings were rising or falling slightly —- gains or declines of less than 10 percent. And when 8.3: P. earnings were falling sharply - 10 percent to 25 percent —- the index gained an aston~. ishing 28.7 percent, on average “This generally just shows that from a long-term perspective, strong earnings growth in ad of itself is not that bullish.” said Tim Hayes, global equity snares-is: at Ned Davis Research. But that finding is less counter-intuitive than it may seam. “The market tends to anticipate, to discount earn- ings growth Well in advance of it happen- ing." Mr. Hayes said. “So by the time you get the peak earnings growth, the market tends to have discounted i ” This anticipatory characteristic of the market means that stocks mm in their best performances when earnings are disap- pointing. Oniy in hindsight does it become clear that stock prices moved higher be- cause investors had perceived that earnings were bottoming out and about to mrnup. Not that earnings growth is bad for stocks, of course. It’s simply that big jumps in profits cannot be expected to support stock prices that have already been levitat- ing for some time. I“What really drives stocks iswhat people are expecting,” Hayes said. "if expecta: tions are really high, you’ re setn‘ng yourself up for disappointment.” And what does that mean for stocks? In the current market, where many of the pigs gest and most popular stocks are still priced for perfection, it just may be that perfection -—a is not enough. L.) THE WALLSTREE'I‘ JOURNAL TUESDAY, MAY 4. 1999 3 Investing Ideas That Stand Test of Time The more I learn. the less I know. When I started writing about personal finance. I eagerly waded into the pool of investment ideas. looking for some opinions to call my own. But most of the beliefs I adopted haven‘t stood the test of time. Indeed. these days I find I am left with just three core in- vestment ideas: I Financial success is a sense of control. If you ask folks about their financial goals. they will likely offer a laundry list of goods they want to buy or announce they want to accumulate as much . money as possible. But in reality. both goals are a prescription for unhappiness. Sure, it might be nice to purchase every- thing that catches your fancy. But nobody has unlimited wealth. so a focus on endless con- sumption inevitably results not in happiness. but in frustration and financial stress. ' Yeah, it would also be great to have heaps of money. But if all you want is an ever-bigger pile of cash. you will never be satisfied. be cause you will never reach your goal. So what should you shoot for? A far more worthy goal. I believe. is eliminating the anxi- ety that comes with managing money. You want to reach that sweet spot where you feel your fi- nances are under control. no matter what your standard of living and level of wealth. l Investing is simple. No doubt about it. there are lots of in‘ vestments and investment strategies that are mighty complicated. But com plexity usually means investors are running the risk of rotten results and Wall Street is getting the chance to charge fat fees. Investing is best when it is simplest. In fact. if you want to accumulate a healthy nest egg. there isn't much to it. First. you have to save a goodly amount. preferably at least 10% of your pretax annual income. Second, you should consider investing at least half of your port- folio in stocks. even if you are approaching retirement. Third. you should diversify broadly. owning a decent mix of large. 'Small and foreign stocks. Fourth. you should hold down investment costs. including brokerage commissions, annual fund expenses and taxes. Finally, you should give it time. A little humility also helps. Don’t waste effort—and risk havoccby trying to pick the next hot stock. identify the next su~ perstar fund manager or guess the market’s next move. histead. your best bet is to buy and hold a few well-run mutual funds. . On that score. I favor putting together a global portfolio of ' market-tracking index funds. You might combine 75% in a fund that tracks the Wilshire 5000 index. which has nearly'all publicly traded U.S. stocks. with a 25% stake in a broad-based international stock-index fund. . Fidelity Investments. T. Rowe Price Associates. Charles Schwab Corp.. Vanguard Group and Wilshire Associates all offer Wilshire 5000 funds. Meanwhile. you can purchase in- ternational-index funds from firms like Fidelity. Schwab and Vanguard. Does indexing sound dull? It may be. But no other strategy offers the same elegant combi- nation of simplicity. low cost. tax efficiency and relative performance predictability. With index funds. your results are still at the whims of the market. But you have the comfort of knowing you won't badly lag be- hind the market averages. Whatever the markets deliver. that is what you will get. I We are the enemy. If successful investing is so simple. why do so many people mess up? It isn‘t the markets that are the problem. It‘s investors. We make all sorts of mistakes. We fret about the performance of each in. vestment we own. so we don't enjoy the full benefits of diversification. We are of~ ten overly self-confident. which prompts us to trade too much and bet too heavily on a single stock or market sector. We extrapolate recent results. lead ing to excessive exuberance when stocks are rising and unjustified pessimism when markets decline. We lack self-con~ trol. so we don‘t save enough. If you are going to be a successful and happy investor. it isn't enough simply to devise strategies that allow you to meet your investment goals. Your strategies also have to give you a sense of financial control and fit with your risk tolerance. so that you stick with them through the inevitable market turmoil. That may mean keeping more of your money in bonds and money-market funds. It could mean paying for an investment adviser. It might mean scaling back your financial goals and accepting that the kids won't be heading to Harvard and that you won't be able to retire early. These sorts of choices aren't foolish. What's foolish is set. tling on investment strategies without considering whether you can see them through. “0'35 uemou Journal Link: Join Jonathan Clements to discuss per- - v sonal finance at 1 p.111. EDT today at nun://wq.eom VWSC!’ Hal. 1‘! mt Indexes: Why the Critics Arc Wrong@ By BURTON G. MALKIEL Buying and holding the hundreds of stocks making up the broad stock market averages is likely to be the most sensible investment strategy for both individual ‘and institutional investors. I’ve argued this for nearly 30 years, since even before index funds existed. The way I put it in 1973, when the first edition of “A Random Walk Down Wall Street" was published. was that a blindfolded chimpanzee throw 1 ing darts at The Wall Street Journal could select a portfolio that would do as well as the experts. In practice. the recom- mended strategy is to throw a towel over. the stock pages ‘and buy and passively hold the entire market portfolio, as can now be done through several broad-based index funds. Time has been very kind to my thesis. The broad capitalization‘weighted indexes regularly outperform about twothirds of the actively managed mutual funds. and the fund managers who beat the index in one period are unlikely to do so in the next. In most years. a Standard & Poor’s 500 in- dex fund has a rate of return about two per- centage points better than the average manager’s; for the 10 years ending in 1998, the index outperformed the average man- ager by 3.5 percentage points. and did bet- ter than more than nine out of 10 active managers. Over the past 30 years. a $10,000 investment in the index would have grown to $311,000 (after expenses); in the average general equity fund, the same investment would have grown to $171,950. No Help . A very few active managers have man- aged to beat the index over long periods. But there is no way to tell in advance who they will be. and the past record of a fund is no help in predicting how it will do in the future. The top funds of the 19805 have. as a group, underperiormed in the ‘905. Why does indexing outmaneuver the best minds on Wall Street? Paradoxically, it is because the best and brightest in the fi nancial community have made the stock market very efficient. When information - arises about individual stocks or the mar- . ket as a whole, it gets reflected in stock «prices without delay. making one stock as . reasonably priced as another. Active man~ E 'agers who frequently shift from security to ; security actually detract from perfor- ; mance by incurring transaction costs amounting to 0.75% to 1% of assets. More . over, the average active fund manager 3 pockets about 1-5% of assets to pay for mar- i keting, research. and manager compensa- : tion. Index funds typically charge less than ' 0.2%. V For all the attractions of indexing. it has elicited a chorus of criticism from the fi- nancial community. Let’s examine their arguments. ' Indexing only works in rising markets. It is true that the advantages of index funds are likely to be somewhat dimin- ished during down markets, because they hold no cash while the typical active man- ager has between 5% and 10% of his portfo- ' lie in cash. thus cushioning the decline. But the record shows that index funds con- tinue to outperform active ones in most down markets. thanks to their substantial expense- and transaction-cost advantage. And don't hold out hope that your actively managed fund will wisely increase its cash position before a market decline. Market timing is more likely to bun performance, for the typical fund lowers its cash position during market peaks and increases it at market troughs. ° Indaring is selffuh'illing and ulti- mately selfdejeating. With the popularity in recent years of mimicking the S&P aver- age. the argument goes. the inflow of funds has boosted the prices of S&P stocks and has led to the self-fulfilling result that in- dex funds have widely outperformed active managers. The result. according to critics, is that the S&P is now bloated with vastly overpriced stocks and will ultimately come crashing down much like the “nifty fifty” stocks of an earlier decade. In truth, despite the increased popular- ity of indexing. its impact is still small rel- ative to the general flow of funds into the Indexing allows in- vestors to buy securities of all types with no effort, minimal expense and con- siderable tax savings. equity market. Indexed funds currently comprise only 9% of all equity mutual funds. Even during 1998, a year of enor— mously increased popularity of indexed eq-_ uity funds. less than one—quarter of the net cash flow went into index funds, and only 16% went into 58:? 500 funds. In addition, careful empirical work finds no relation ship between changes in the relative flow of money into index funds and the amount by which the index oumerforms active managers. ' . 0 If everyone indexes. there will be n professionals left to ensure that the market is efficiently priced. This worry is mis- "money. Hull" placed. Most investment money is actively managed; professional security analysts and money managers are nowhere near extinction. ' Mating doesn't work in less efficient markets. Some professionals grudgingly admit that indexing probably works for big companies. but they argue that it cannot ‘ work in the less efficient parts of the mar- ket such as smaller company stocks. and certainly not in the notoriously mefficrent emerging markets. In fact. indexing can have even greater advantages in less effi' cient markets. Small’cap markets and es- pecially emerging markets tend to be quite illiquid. Bid-asked spreads are large. and it 15 impossible to buy or sell blocks of stock without considerable market imPaCL Hence the transaction costs of actively trading in these markets tend to be far larger than for big-company stocks. More- over. management costs are substantially higher for funds that invest in small corn- panies and in emerging markets. The en- dence is clear that when active equity man: agers are compared with indexes of stocks with equivalent market capitalizations and With appropriate country benchmarks. in- dex fund investors come out well ahead. ‘ Indexing won't work when large-cap stocks underpm‘m. More than three out of four index funds simply replicate the S&P 500 index. The large-cap domestic stocks that dominate the index have en- joyed unusually superior performance in recent years. One dangerous feature of in- dexing is that the investor automatically increases the portfolio weighting of stocks that have been increasing in price and thus constitute a bigger share of the index. If the new “nifty fifty” begin to underper- form. the advantage of 88:? 500 indexing v will sharply narrow. This is an argument for which I have considerable sympathy. It may well be that better values in the market today can be found in small-cap stocks. in real estate eq- uities. in bonds and even in the stocks of the battered emerging markets. But this is not an argument against indexing. in~ vestors today have available to them index funds that invest in a wide variety of do- mestic and international securities. More- over. there are “total stock market" index funds that replicate indexes of several thousand securities. The argument that largecap stocks are pricey relative to the rest of the market is not an argument against indexing. but rather a call to in- vestors to use care in deciding which index fund or combination of funds they should select for their particular needs. Deadweight Loss In addition to the cost advantages. in- dexing provides enormous tax benefits for taxable investors. An actively managed fund trades, and thus realizes capital _ gains, much more frequently than an index fund does. Even with long-term capital gains tax rates reduced to 20%. an active manager would need significant overper- forrnance relative to the index to make up for the deadweight loss of taxes. Indexing allows investors to buy securi~ ties of all types with no effort, minimal ex- - pense and considerable tax savings. Index- ing is a winning investment strategy whose recent growth‘refleqts a realistic ad- justment of individual investors. to a not— so-well-kept secret of the investment busi- ness: Professional portfolio managers are unable to beat the market consistently. All intelligent individual investors should have index funds at the core of their portfo- lios. Mr. Malkiel is the author of “A Random Walk Down Wall Street.” the updated. set:- enth edition of which has just been published by W. W. Norton. . Stock Characters As Two Economists Debate Markets, The Tide Shifts Beiief in Efficient Markets Yields Ground to Role - Of Irrational Investors Mr. Thaler Takes On Mr. Fama By JON E. HILSENRATH For forty years, economist Eugene Fama argued that financial markets were highly efficient in reflecting the un- derlying value of stocks. His long-time intellectual nemesis, Richard Thaler, a member of the “behaviorist” school of economic thought, contended that mar- kets can veer off course when individuals make stupid decisions. In May, 116 eminent economists and business executives gathered at the Uni— versity of Chicago Graduate School of Business for a con- ference in Mr. Fa- ma’s honor. There, Mr. Fama sur- prised some in the audience. A paper he presented, co-au- thored with a col- league, made the case that poorly in- formed investors could theoretically Eugene Fama lead the market —— astray. Stock prices, the paper said, could become “somewhat irrational.” Coming from the 65-year-old 'Mr. Fama, the intellectual father of the the- ory known as the “efficient-market hy- pothesis,” it struck some as an unex- pected concession. For years, efficient market theories were dominant, but here was a suggestion that the behaviorists’ ideas had become mainstream. “I guess we're all behaviorists now,” Mr. Thaler, 59, recalls saying after he heard Mr. Fama’s presentation. Roger lbbotson, a Yale University pro- fessor and founder of lbbotson Associates Inc., an investment advisory firm, says his reaction was that Mr. Fama had “changed his thinking on the subject” and adds: “There is a shift that is taking place. People are recognizing that mar- kets are less efficient than we thought.” Mr. Fama says he has been consistent. .. yuan-w, - counts for their re- The shift in this long-running argu- ment has big implications for real-life problems, ranging from the privatization of Social Security to the regulation of fi- nancial markets to the way corporate boards are run. Mr. Fama’s ideas helped foster the free-market theories of the 19805 and spawned the $1 trillion index- fund industry. Mr. Thaler’s theory sug- gests policy makers have an important role to play in guiding markets and indi- viduals where they’re prone to fail. Take, for example, the debate about Social Security. Amid a tight election bat- tle, President Bush has set a goal of partially privatiz— ing Social Security by allowing younger workers to put some of their payroll taxes into private savings ac- tirements. In a study of Sweden‘s efforts to privatize its retire- ' I . ment system, Mr. Richard Thaler Thaler found that _“—’—— Swedish investors tended to pile into risky technology stocks and invested too heavily in domestic stocks. Investors had too many options, which limited their ability to make good decisions, Mr. Tha- ler concluded. He thinks U.S. reform, if it happens, should be less flexible. “If you give people 456 mutual funds to choose from, they’re not going to make great choices,” he says. If markets are sometimes inefficient, and stock prices a flawed measure of value, corporate boards and manage- ment teams would have to rethink the way they compensate executives and judge their performance. Michael Jensen, a retired Harvard economist who Please Turn to Page A16, Column 3 Continued From First Page worked on efficient-market theory ear- lier in his career, notes a big lesson from the 1990s was that overpriced stocks could lead executives into bad decisions, such as massive overinvestment in tele- communications during the technology boom. Even in an efficient market, bad in- vestments occur. But in an inefficient market where prices can be driven way out of whack, the problem is acute. The solution, Mr. Jensen says, is “a major shift in the belief systems" of corporate boards and changes in compensation that would make executives less focused on stock price movements. Few think the swing toward the behav- iorist camp will reverse the global empha- sis on open economies and free markets, despite the increasing academic focus on market breakdowns. Moreover, while Mr. Fama seems to have softened his think- ing over time, he says his essential views haven’t changed. A product of Milton Friedman’s Chi- cago School of thought, which stresses the virtues of unfettered markets, Mr. Fama rose to prominence at the Univer- sity of Chicago’s Graduate School of Busi- ness. He’s an avid tennis player, known for his disciplined style of play. Mr. Tha- ler, a Chicago professor whose office is on the same floor as Mr. Fama’s, also plays tennis but takes riskier shots that sometimes land him in trouble. The two men have stakes in investment funds that run according to their rival eco- nomic theories. Highbrow Insults Neither shies from tossing about high- brow insults. Mr. Fama says behavioral economists like Mr. Thaler “haven’t re- ally established anything” in more than 20 years of research. Mr. Thaler says Mr. Fama “is the only guy on earth who doesn’t think there was a. bubble in Nas- daq in 2000.” In its purest form, efficient-market theory holds that markets distill new in- formation with lightning speed and pro- vide the best possible estimate of the un- derlying value of listed companies. As a result, trying to beat the market, even in the long term, is an exercise in futility because it adjusts so quickly to new infor- mation. Behavioral economists argue that markets are imperfect because people of- ten stray from rational decisions. They believe this behavior creates market breakdowns and also buying opportuni- ties for savvy investors. Mr. Thaler, for example, says stocks can under-react to good news because investors are wedded to old views about struggling companies. For Messrs. Thaler and Fama, this is more than just an academic debate. Mr. Fama’s research helped to spawn the idea of passive money management and index funds. He’s a director at Dimen- sional Fund Advisers, a private invest- ment management company with $56 bil- lion in assets under management. Assum- ing the market can’t be beaten, it invests in broad areas rather than picking indi- vidual stocks. Average annual returns over the past decade for its biggest fund—- one that invests in small, undervalued stocks—have been about 16%, four per- centage points better than the S&P 500, according to Morningstar Inc., a mutual- . fund research company. Mr. Thaler, meanwhile, is a principal at Fuller & Thaler, a fund management company with $2.4 billion under manage- ment. Its asset managers spend their time trying to pick stocks and outfox the market. The company’s main growth fund, which invests in stocks that are expected to produce strong earnings growth, has delivered average annual re- turns of 6% since its inception in 1997, three percentage points better than the S&P 500. Mr. Fama came to his views as an undergraduate student in the late 1950s at Tufts University when a professor hired him to work on a market-forecast- ing newsletter. There, he discovered that strategies designed to beat the market didn’t work well in practice. By the time he enrolled at Chicago in 1960, econo- mists were viewing individuals as ra- tional, calculating machines whose be- havior could be predicted with mathemat- ical models. Markets distilled these dif- fering views with unique precision, they argued. “In an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value,“ Mr. Fama wrote in a 1965 paper titled “Random Walks in Stock Market Prices.” Stock movements were like “random walks” because investors could never pre- dict what new information might arise to change a stock’s price. In 1973, Princeton economist Burton Malkiel published a popularized discussion of the hypothesis, “A Random Walk Down Wall Street,” which sold more than one million copies. Mr. Fama’s writings underpinned the Chicago School’s faith in the functioning of markets. Its approach, which opposed government intervention in markets, helped reshape the 19803 and 1990s by encouraging policy makers to open their economies to market forces. Ronald Rea- gan and Margaret Thatcher ushered in an era of deregulation and later Bill Clin- ton declared an end to big government. After the collapse of Communist central planning in Russia and Eastern Europe, many countries embraced these ideas. As a young assistant professor in Rochester in the mid—1970s, Mr. Thaler had his doubts about market efficiency. People, he suspected, were not nearly as rational as economists assumed. Mr. Thaler started collecting evidence to demonstrate his point, which he pub- lished in a series of papers. One associ- ate kept playing tennis even though he had a bad elbow because he didn’t want to waste $300 on tennis club fees. Another wouldn’t part with an expensive bottle of wine even though he wasn’t an avid drinker. Mr. Thaler says he caught econo— mists bingeing on cashews in his office and asking for the nuts to be taken away because they couldn’t control their own appetites. Mr. Thaler decided that people had systematic biases that weren’t rational, such as a lack of self-control. Most econo- mists dismissed his writings as a collec- tion of quirky anecdotes, so Mr. Thaler decided the best approach was to debunk the most efficient market of them all— the stock market. Small Anomalies Even before the late 19905, Mr. Thaler and a growing legion of behavioral fi- nance experts were finding small anoma- lies that seemed to fly in the face of effi- cient-market theory. For example, re- searchers found that value stocks, compa- nies that appear undervalued relative to their profits or assets, tended to outper- form growth stocks, ones that are per- ceived as likely to increase profits rap- idly. If the market was efficient and im- possible to beat, why would one asset class outperform another? (Mr. Fama says there’s a rational explanation: Value stocks come with hidden risks and investors are rewarded for those risks with higher returns.) Moreover, in a rational world, share prices should move only when new infor- mation hit the market. But with more than one billion shares a day changing hands on the New York Stock Exchange, the market appears overrun with traders making bets all the time. Robert Shiller, a Yale University econ- omist, has long argued that efficient-mar- ket theorists made one huge mistake: Just because markets are unpredictable doesn’t mean they are efficient. The leap v in logic, he wrote in the 1980s, was one of “the most remarkable errors in the his- tory of economic thought.” Mr. Fama says behavioral economists made the same mistake in reverse: The fact that some individuals might be irrational doesn’t mean the market is inefficient. Shortly after the stock market swooned, Mr. Thaler presented a new pa— per at the University of Chicago’s busi- ness school. Shares of handheld-device maker Palm Inc—which later split into two separate companies—soared after some of its shares were sold in an initial public offering by its parent, 3Com Corp., in 2000, he noted. The market gave Palm a value nearly twice that of its parent even though 3Com still owned 94% of Palm. That in effect assigned a negative . value to 3Com’s other assets. Mr. Thaler titled the paper, “Can the Market Add and Subtract?” It was an unsubtle shot across Mr. Fama’s bow. Mr. Fama dis- missed Mr. Thaler’s paper, suggesting it was just an isolated anomaly. “Is this the tip of an iceberg, or the whole iceberg?” he asked Mr. Thaler in an open discus- sion after the presentation, both men re- call. Mr. Thaler‘s views have seeped into the mainstream through the support of a number of prominent economists who have devised similar theories about how markets operate. In 2001, the American v Economics Association awarded its high- est honor for young economists—the John Bates Clark Medal—to an econo- mist named Matthew Rabin who devised mathematical models for behavioral theo- ries. In '2002, Daniel Kahneman won a Nobel Prize for pioneering research in the field of behavioral economics. Even Federal Reserve Chairman Alan Greenspan, a firm believer in the bene— fits of free markets, famously adopted the term “irrational exuberance” in 1996. Andrew Lo, an economist at the Mas- sachusetts Institute of Technology's Sloan School of Management, says effi- cient-market theory was the norm when he was a doctoral student at Harvard and MIT in the 1980s. “It was drilled into us that markets are efficient. It took me five to 10 years to change my views.” In 1999, he wrote a book titled, “A Non-Random Walk Down Wall Street.” In 1991, Mr. Fama’s theories seemed to soften. In a paper called “Efficient Capital Markets: 11," he said that market efficiency in its most extreme form—the idea that markets reflect all available in— formation so that not even corporate in- siders can beat it—was “surely false.” Mr. Fama’s more recent paper also tips its hand to what behavioral economists have been arguing for years-that poorly informed investors could distort stock prices. But Mr. Fama says his views haven't changed. He says he's never believed in the pure form of the efficient-market the- ory. As for the recent paper, co-authored with longtime collaborator Kenneth French, it “just provides a framework” for thinking about some of the issues raised by behaviorists, he says in an e-mail. “It takes no stance on the empiri- cal importance of these issues." The 19905 Internet investment craze, Mr. Fama argues, wouldn’t have looked so crazy if it had produced just one or two blockbuster companies, which he says was a reasonable expectation at the time. Moreover, he says, market crashes confirm a central tenet of efficient mar— ket theory—that stock-price movements are unpredictable. Findings of other less significant anomalies, he says, have grown out of “shoddy” research. Defending efficient markets has got- ten harder, but it’s probably too soon for Mr. Thaler to declare victory. He con- cedes that most of his retirement assets are held in index funds, the very indus- try that Mr. Fama’s research helped to launch. And despite his research on mar- ket inefficiencies, he also concedes that “it is not easy to beat the market, and most people don’t.” ...
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