Why financial markets are inefficient
Roger E. A. Farmer 22 January 2013
The efficient market hypothesis – in various forms – is at the heart of modern finance and macroeconomics. This column argues that market efficiency is extremely unlikely even without frictions or irrationality. Why? Because there are multiple equilibria, only one of which is Pareto efficient. For all other equilibria, the whims of market participants cause the welfare of the young to vary substantially in a way they would prefer to avoid, if given the choice. This invalidates the first welfare theorem and the idea of financial market efficiency. Central banks should thus dampen excessive market fluctuations.
Writing in a review of Justin Fox’s book The Myth of the Efficient Market, Richard Thaler (2009) has drawn attention to two dimensions of the efficient markets hypothesis, what he refers to as:
Financial markets Macroeconomic policy
efficient market hypothesis, Finance, first welfare theorem, market fluctuations
New light on choice of investment strategy
Dimitri Vayanos, Paul Woolley 18 January 2012
According to classical economics, there are no gains to be made in an efficient market. Yet markets are often far from efficient and the gains are often far from insignificant. So should investors follow the herd or rely on best guesses of fair value? This column argues that the optimal strategy depends on whether you are in for the short or long term.
January finds many pondering the issue of what to do with their savings in the new year. There are two primary and distinct techniques of asset management: momentum and fair value.
investment, efficient market hypothesis, investment strategy
Capital market theory after the efficient market hypothesis
Dimitri Vayanos, Paul Woolley 05 October 2009
Have capital market booms and crashes discredited the efficient market hypothesis? This column says yes and suggests a new model that explains asset pricing in terms of a battle between fair value and momentum driven by principal-agent issues. Investment agents’ rational profit seeking gives rise to mispricing and volatility.
Forty years have passed since the principles of classical economics were first applied formally to finance through the contributions of Eugene Fama (1970) and his now-renowned fellow academics. Over the intervening years, capital market theory and the efficient market hypothesis have been developed and modified to form an elegant and comprehensive framework for understanding asset pricing and risk.
asset pricing, Behavioural economics, efficient market hypothesis