25 Mar 2015

Financiers vs. Academic Economists

Economics, Efficient Markets Hypothesis, Eugene Fama 5 Comments

My friend tipped me off to this speech by Charlie Munger that is quite provocative and funny, mostly because he says stuff that only rich old guys can get away with saying. For context, Munger is Vice-Chairman at Berkshire Hathaway, and apparently Warren Buffett refers to Munger as “my partner.” Munger is a self-made man worth more than a billion, who has made many millions of dollars worth of philanthropic donations.

What amused me most was Munger’s discussion of the Efficient Markets Hypothesis:

[E]conomics is in many respects the queen of the soft sciences. It’s expected to be better than the rest. It’s my view that economics is better at the multi-disciplinary stuff than the rest of the soft science. And it’s also my view that it’s still lousy, and I’d like to discuss this failure in this talk. As I talk about strengths and weaknesses in academic economics, one interesting fact you are entitled to know is that I never took a course in economics. And with this striking lack of credentials, you may wonder why I have the chutzpah to be up here giving this talk. The answer is I have a black belt in chutzpah. I was born with it. Some people, like some of the women I know, have a black belt in spending. They were born with that. But what they gave me was a black belt in chutzpah.

For a long time there was a Nobel Prize-winning economist who explained Berkshire Hathaway’s success as follows:

First, he said Berkshire beat the market in common stock investing through one sigma of luck, because nobody could beat the market except by luck. This hard-form version of efficient market theory was taught in most schools of economics at the time. People were taught that nobody could beat the market. Next the professor went to two sigmas, and three sigmas, and four sigmas, and when he finally got to six sigmas of luck, people were laughing so hard he stopped doing it.

Then he reversed the explanation 180 degrees. He said, “No, it was still six sigmas, but is was six sigmas of skill.” Well this very sad history demonstrates the truth of Benjamin Franklin’s observation in Poor Richard’s Almanac. If you would persuade, appeal to interest and not to reason. The man changed his view when his incentives made him change it, and not before.

Now to be sure, the PhDs in Chicago and elsewhere can always come up with ways to incorporate the empirical facts into their theory. But that’s the point I have been making for years: In practice, economists believe in the Efficient Markets Hypothesis as a framework with which to interpret the world. That’s not a bad thing per se, but they should stop thinking that they are “letting the data speak for themselves.”

The best example of this was after the financial crash of 2008. There were academic economists and finance guys explaining that the crash just proved how efficient the stock market was! Specifically, Jeremy Siegel argued in the WSJ that, “The EMH, originally put forth by Eugene Fama of the University of Chicago in the 1960s, states that the prices of securities reflect all known information that impacts their value…The fact that the best and brightest on Wall Street made so many mistakes shows how hard it is to beat the market” (italics added).

I hope I don’t need to tell the reader that during the boom years, with executives earning bonuses and “quants” getting paid top dollar to use physics models to price derivatives, people weren’t writing op eds in the WSJ explaining that this success disproved the EMH.

I don’t mean to be too hard on the academic economists who are so enamored with their beautiful theories. Before the financial crisis, I too was far too trusting of our current financial system’s ability to quickly weed out systematic errors, and I thought much more of the Chicago School’s approach to modeling the financial market than I do today. One of the biggest differences between real-world investors and academics is that nothing really bad happens to you if you’re systematically wrong in academia.

5 Responses to “Financiers vs. Academic Economists”

  1. Mule Rider says:

    “…is that nothing really bad happens to you if you’re systematically wrong in academia.”

    *cough* Krugman *cough*

  2. Jeff says:

    EMH is a construct to help make sense of the world, like Mises’ evenly rotating economy (not to say that they are the same) or general equilibrium in the neoclassical sense. Moreover, it’s badly communicated and badly understood. We financial economists say that the EMH would obtain in a perfect world where all relevant information is known by all market participants. So it’s a way of describing that world, but we realize the real world is full of frictions that take us away from efficiency.

  3. Tel says:

    Actually this is one topic I was hoping to get the Murphy’s Digest Explained in Simple Words edition.

    I understand the principle of EMH where the market is self optimizing, and the arbitrage eats up any slack, information propagates through the system and (if left undistributed, which never really happens and cannot happen, but ignore that) it settles to a steady equilibrium and the most efficient operating point. Or that’s the theory.

    Then we go to the empirical side of it, and it says that if markets were inefficient, we would observe some shape of curve that would be demonstrably different from what we observe when they are efficient… and this implies some deep different mechanism between efficient and inefficient markets. This is the bit where I come unstuck. Where is the reference here? In any given scope (e.g. the international oil price) we have only one market happening at any one time. What do we compare it to? Can someone explain how that part of it works?


    So hypothetically speaking, I’m passed out drunk under some shrubbery, and as I stir softly back to my senses I happen to hear a snatch of passing conversation and I think, “that’s going to cause the price of gold to shoot right up”.

    Now it seems that “the market” couldn’t have priced that in just yet, I only just overheard it, but if I act on the information then I’d be influencing the price and cause it to move to a new equilibrium where it might be priced in. My point is that if all information was always priced in immediately then no one would buy and no one would sell any equity (they may well buy and sell other things, but stocks would not furiously trade back and forth across the exchange floor).

    I mean if I was to swap my chocolate ice cream for your vanilla, it could be explained in terms of preferences, but with us exchanging back and forth the same ice cream there must be something else going on. The market must execute some tangible operation in order to process the information that comes in the door. It is possible to front run if you know something no one else knows at that time. In effect you are selling the knowledge to others.

    You end up with the idea that the King has the support of almighty God… because after all, if God didn’t want him to be King, God wouldn’t have allowed him to get there in the first place.

    That doesn’t make it impossible for someone to come along and defeat the old King, thus making themselves the new King… it just happened because God wanted it that way (or the market wanted it, maybe they both did).

  4. S.C. says:

    I never saw how the EMH ever held any relevance.

  5. Major.Freedom says:

    Sometimes I think the psychological motivation for the creation of EMH in academic circles was for low paid economists to justify to themselves and their families why they are not wealthy.

    Saying bad luck is easier than saying I’m relatively too dimwitted.

    EMH is certainly not a product of historical data.

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