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Wednesday, October 16, 2013

Fama, Shiller, Hansen


  1. Disappointing that the author over-glorifies Fama and under-appreciates Shiller. And, this lumping together of two very disparate theories under the same general umbrella of understanding asset prices is bizarre and disingenuous from the Nobel committee.

    Why should unpredictability be consistent with efficiency? The market can stay irrational longer than one can remain solvent should be a valid counter-argument here. In other words, there is no reason why inefficient markets cannot be unpredictable. Why is this commonsense argument not made, I will never know.

    Second argument is that the market provides feedback into reality, so reality can catch up to markets or vice versa and the market is an active participant in manipulating reality. So, to look at markets as a passive observer or consumer of information is wrong. Something like Soros' theory of reflexivity is nearer to reality. And similar ideas are formulated by behavioral economists as well. Of course, no serious finance scholar will take Soros's theory seriously, so I would point out MIT's Lo and MacKinlay's Adaptive Markets Hypothesis. Their book "A Non-Random Walk Down Wall Street" points out why the random walk hypothesis is wrong.

    But mainstream economists (or in the words of the author, every serious finance scholar) won't go that route as it makes life difficult for them. Because, where is the easy path from those assumptions?

    The common argument that only 1% of active investors outperform the average or that every serious finance scholar knows that they cannot outperform the market is wrong in so many ways. First of all, this is the case in most professions. Probably only 1% of writers write bestsellers. According to efficient theorists, only 1% of JEE applicants make it through to IIT and the average applicant does not make it to IIT, so no serious student should attempt to outperform on the JEE. An absurd argument.

    What is even more absurd is that if there are no active investors, there is no competitive market and no efficient market, so the whole argument collapses on itself. The argument that indexing is better can apply to non-finance professionals, because that is not their area of expertise. But, the author is applying this argument to "every serious finance scholar" which is so very wrong as is born out by reality and the arguments made here. The situation is no different than in any competitive, free market profession. Applying the same argument to other professions would mean that no serious professional should try to do better than average in his/her profession, which is impractical, but then impracticality is suspended when talking about efficient markets. Oh well...

    1. I'm delighted that Shiller spoke about the "discordant" grouping of ideas by the Nobel committee in an interesting article:

  2. I would agree with reviewer Vivek's comments and would like to supplement it. Market efficiency, i.e. stock prices move randomly does not necessarily imply absence of bubbles, a comparison, which' every serious finance scholar' is prone to make. Imagine stock pricees move in tandem with the results of biased coin (biased in favour of head). Even in these case while heads are more likely, nevertheless, every outcome is still random, i.e. one cannot still predict with certainty the stock price movements. Over a period of time, such a bias however shows up as prices move away from'fundamentals', a bubble scenario (incidentally a word, you cannot utter in Fama's presence). Hence Fama's model is better seen as a short term pricing tool , nothing more-nothing less. He surely deserves the prize though

  3. Mostly agree with the comments above, disappointing article from Mr Ajay Shah.

  4. Poolla R.K. Murti

    1. The erudite comments presented so far are well appreciated.

    2. I wish to submit that FAMA is well aware of the limitations of the assumptions of the "Random walk Model". I wish to quote from his celebrated Paper on Efficient Capital Markets II "Since there are surely positive information and trading costs, the extreme version of the market efficiency hypothesis is surely false. Its advantage, however, is that it is a clean benchmark that allows me to sidestep the messy problem of deciding what are reasonable information and trading costs. I can focus instead on the more interesting task of laying out the evidence on the adjustment of prices to various kinds of information. Each reader is then free to judge the scenarios where market efficiency is a good approximation (that is, deviations from the extreme version of the efficiency hypothesis are within information and trading costs) and those where some other model is a better simplifying view of the world" {Jr of Finance, Vol 46, issue 5, Dec 1991) This should be kept in mind while studying his seminal Paper:on Efficient Capital Markets presenting the Random Walk Model (Jr of Finance, Vol 25, issue 2, May 1970) "under the assumption that security prices at any time “fully reflect” all available information. A market in which prices always “fully reflect” available information is called “efficient.”. As such, Fama's assumptions (based on which the Random Walk Model gets evolved) are fairly clear while it is another matter (which should in no way detract from the great Author's Contribution) how far the assumptions are far from the "real world".

    3. Apart from the subject, I would also submit the mean-variance Theory of Stock Returns is based on the basic assumption that Stock Returns can be modeled by the Normal Distribution while experience shows that a skewed Distribution may be more realistic.

    4. The above points are presented to elicit more scholarly discussion from both gifted Academics and practitioners of the Capital Markets. I am merely a student of Finance and wish to learn from Scholars of the Subject.

    5. FAMA, of course, has carved for himself a highly respectable place in the "Theory of Finance" (in a lighter vein, I failed in my Finance Course in the Katholic University of Leuven in 1978 because I could not understand his Theory that time!) Let us hive him the noblest academic accolades as also to Professor Ajay Shah for so succinctly presenting FAMA in an admirable fashion.


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