“Give me a one-handed economist. All my economists say, ‘on the one hand…on the other'” – Harry Truman, American President.
In the 1960’s, a young Eugene Fama developed a profound insight about the markets. Fama observed that over the short term, equity markets behave randomly. The day-to-day, week-to-week trading action has no rhyme or reason. Indeed, the random walk of markets makes them effectively impossible to predict in that time frame. The Efficient Market Hypothesis, as Fama called it, meant that stock-picking was a futile exercise.
The relevance to finance was soon obvious: Most investors are better off owning the entire market, rather than guessing which stocks might do better or worse. For this, Fama is thought of as the intellectual father of indexing.
And then Fama blew it. Fama took the idea of efficient markets to an illogical extreme. He made a leap of faith based largely on the earlier flawed analysis that led him to the correct conclusion that markets behave randomly. Because markets reflect all known information in their prices, Fama rationalized, most of the rules and regulations related to securities were unnecessary. Even worse, he reasoned, they were counterproductive because they interfered with the price discovery process.
Professor Robert Shiller‘s data, on the other hand, overwhelmingly showed that markets were at times as irrational as the humans who traded them. Bubbles formed, prices detached from reality, then just as soon came back to Earth. This was hardly informational efficiency. Shiller is said to have remarked that “The efficient-markets hypothesis is the most remarkable error in the history of economic theory.” Sometimes prices had nothing whatsoever to do with the available information — except the insight that people occasionally went crazy.
With the Nobel Prize in economics being awarded to both Fama and Shiller, it appears that academia has finally accepted the fact that on on hand, markets are rational, but on the other…
Source: How Shiller helped Fama win the Nobel
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