Are Financial Markets Efficient?
The efficient markets hypothesis (EMH) was developed in the 1960s to rationalize the empirical observation that security prices fluctuate randomly. According to EMH, the random character of security prices is simply a reflection of the fact that security markets are efficient. In efficient markets, new information comes to the market erratically and gets quickly reflected in security prices, thus causing random movements in these prices. As expected, EMH proved highly congenial to free market enthusiasts, who believed that financial markets could self-regulate and, hence, had no need of government supervision. In fact, throughout the 1960s and 1970s, considerable evidence was marshalled by proponents of EMH to document its empirical validity. According to this evidence, while security prices can depart from their investment values in the short run, they will always return to these values in the long run.
Beginning in the early 1980s, however, new evidence began to surface that seriously challenged EMH. In particular, it was shown that security prices often fluctuate much more than justified by changes in their fundamentals. In addition, evidence emerged that security prices frequently deviate from their correct values for extended periods of time. These findings were particularly reinforced by the stock market crash of October 19, 1987, where stocks lost 22 percent in a single day, without any significant news. Thus, it seemed that security prices could sometimes move as a result of their own internal dynamics, without any need for external news. For example, to avoid interest costs, many leveraged investors will simply liquidate their positions, rather than cope with the consequences of a flat market. In such situations, therefore, no news is apparently bad news. EMH received additional bad marks, as financial markets displayed greater volatilities throughout the 1990s and the 2000s, culminating in the severe 2008-2009 financial crisis. During this crisis, hundreds of billions of dollars of mortgage-backed securities went essentially worthless, resulting in all major US investment banks going effectively bankrupt. Consequently, many investors began to lose confidence in EMH and its assertion that the financial system is an infallible and rational information-processing machine.
The shaky performance of EMH during the Great Recession has in turn created a field day for behavioral finance, a school of thought which is highly critical of EMH for its emphasis on the rationality of markets. According to this school, almost all financial crises are direct results of investor irrationality, captured by such psychological factors as greed, fear, and overconfidence. In this view, markets are driven largely by waves of investor irrational exuberance or pessimism, causing significant divergences between security prices and their underlying fundamentals.
There is no doubt that behavioral finance provides interesting insights into investor psychological glitches that can affect financial markets. However, it seems too farfetched to attribute general movements in these markets to purely emotional factors. After all, many of these factors have been around for quite a long time, while financial markets have performed quite well on most occasions. It seems more likely that what usually passes for short run irrationality is nothing more than rational behavior in the face of exceptional uncertainties and crisis situations. Being in the dark about the right courses of action, many investors tend to trust the collective judgment of the market by resorting to such apparently irrational behavior as herding.
In summary, financial markets are generally efficient, at least in the long run. In the short run, security prices may deviate from their correct values, reflecting general uncertainty about market fundamentals. In addition, such factors as excessive leverage and unregulated financial derivatives can reinforce short run volatilities in the markets. However, sooner or later security prices are bound to converge to their fundamental values. Obviously, this process can be expedited through greater transparency and closer government regulation.
Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics