Markets Aren’t Efficient After All

What witches, alchemists, fortune tellers and bankers have in common.

Well, well, Martin Wheatley, head of the consumer and markets business unit at the Financial Services Authority, has jumped on the bandwagon disclaiming the Efficient Markets Hypothesis – something that has supposedly underpinned financial markets for four decades.

Eugene Farma’s 1970’s theory says that investors are rational and use publicly available information sensibly when making investment decisions, so that prices always reflect all that is known. If prices are too high, based on this information, investors sell.

The problem is that markets clearly behave far from rationally, as the financial crisis in the US in 2007 and the bursting of bubbles in housing, stock markets and commercial property more recently have shown rather well.

Of course, for fairly obvious reasons, individuals involved in all this stuff are playing their own games and make sure that outcomes favour them. The people working on behalf of investors are greedy, a fairly common human trait it seems, and want a disproportionate cut for themselves.

Methinks the system benefits from pretending that “bubbles” of one sort or another are not a very efficient way of transferring wealth from the naïve investor (most of us) to the canny speculator (the hard-nosed ones). But I would challenge that pretension – they are! Bubbles happen periodically, just far enough apart for us all to have colluded to forget the last nonsensical spate of irrational behaviour. They benefit some, particularly those in the know, but attract the rest of us with the prospect of easy money. For every big winner there are often many smaller losers.

Some people see these economic anomalies coming and clearly take advantage of them. To become better briefed, and maybe spot the next one, take a look at Extraordinary Popular Delusions and the Madness of Crowds, a history of popular folly by Scottish journalist Charles Mackay, published as long ago as 1841. Anyone tempted into thinking they can make an easy speculative buck should read this fascinating book.

The subjects of Mackay’s debunking include: economic bubbles; alchemy; crusades; witch-hunts; prophecies; fortune telling; magnetisers (influence of imagination in curing disease); the shapes of hair and beards (influence of politics and religion on); murder through poisoning; haunted houses; popular follies of great cities; popular admiration of great thieves; duels; and relics.

It isn’t just me who values Mackay’s opinions, by the way. Present day writers on economics, such as Andrew Tobias and Michael Lewis, laud the three chapters on economic bubbles. If you have any money to invest, read this book first. It makes you realise just who benefited from the efficient markets hypothesis and why it has less use for most of us than we were led to believe.

Mark

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