Home ListingMay 1, 2012

Efficient Market Hypothesis Drove Crash, Critics Say

<em>The capital asset pricing model and the efficient market hypothesis reflects the death of investor common sense, claims the 300 Club, noting that such theories contributed to the 2008 financial collapse.</em>

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(May 1, 2012) — The efficient market hypothesis and the capital asset pricing model led to the 2008 financial crisis, a leading group of investors has claimed, calling for immediate action to prevent it from happening again.

“Harry Markowitz, the pioneer of modern investment theory, was the first person to make risk the centerpiece of portfolio management,” says Professor Amin Rajan, chief executive of Create Research and a member of the 300 Club, the group of 10 investment professionals formed to raise awareness of the potential impact of current market thinking.

“This view inspired the origin of the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH), both of which have since dominated portfolio theory. However, the evolution of these two theories led to the inference that markets are efficient and that active management does not work, which is simply untrue.”

According to the investing group, the CAPM argues that by making various assumptions, much of the variation in investment returns comes from market movements, with each investment containing systemic and idiosyncratic risks. Thus, the only reason why an investor should earn more by investing in one stock rather than another is that one is riskier than the other. Furthermore, the group concludes that CAPM not only ignores investors’ behavior biases, but that it also omits other factors that have a significant role in influencing future returns, such as: price-earnings ratios; debt-equity ratios that measure leverage and book-to-market equity ratios.

The biggest disagreement with CAPM, however, has been the supposition that active management does not add value, the 300 Club says.

In addition, while the EMH states that stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices, the group argues that it should be impossible to outperform the overall market through expert stock selection or market timing. “Therefore, passives are bound to beat actives that seek to exploit mispriced assets relative to a risk-adjusted benchmark, since the invisible hand of the market works faster than any single investor,” a release from the group says.

Professor Rajan continued: “Nevertheless, the anomalies mean that the whole paradigm of rational expectations that reigned supreme for nearly fifty years is no more than an ideological aspiration about how markets ought to work under the tenets of neo-classical economics. The crash-landing of its two cherished idols – CAPM and EMH – in 2008 shows all too well that they were as remote from the complexities of markets as the man on the moon. The EMH cultivated a belief that markets are always right, with their own self-correcting fair-value dynamic, and mean reversion towards fundamental values is the norm.”

The 300 Club’s assertions regarding the inadequacies of the CAPM and EMH follow a recent whitepaper by Andrew Lo, a professor at the MIT Sloan School of Management and Chairman and Chief Investment Strategist at AlphaSimplex Group, which claimed that many market participants are now questioning the broad framework in which their financial decisions are being made.

The paper — titled “Adaptive Markets and the New World Order” — asserted that the traditional paradigms of modern portfolio theory and the EMH seem woefully inadequate. “But simply acknowledging that investor behavior may be irrational is cold comfort to individuals who must decide how to allocate their assets among increasingly erratic and uncertain investment alternatives,” wrote Lo. According to the paper, the efficient market hypothesis is not wrong, but incomplete. “Markets are well behaved most of the time, but like any other human invention, they are not infallible and they can break down from time to time for understandable and predictable reasons,” Lo wrote, urging investors to view financial markets and institutions from the perspective of evolutionary biology rather than physics.