November 3, 2006
Eugene Fama, a founding father of the efficient market theory, has a dialogue with Nina Mehtais in the Nov/Dec 2006 issue of Financial Engineering News and the conversation stirs up an old debate anew. Are markets efficient? Is it possible to pick winning stocks? Can investors beat the market? It's an old discussion, but it promises to be a perennial one, and the latest installment from FEN is worth a look, no matter your view. A sample of the Q&A follows below. For the full interview, dive in here.
FEN: If markets are efficient, a stock price reflects the intrinsic value of a company, but does that mean the price is always right?
EF: It means you can’t figure out whether it’s wrong. It’s not always right because there’s some uncertainty about what right is, but basically you just can’t beat it.
FEN: How would you know if a market doesn’t fully reflect all available information about a stock?
EF: If you had the right risk and return story, you’d be able to identify the kinds of information that weren’t incorporated into the price. There are lots of studies where people study the adjustments of stock prices to splits, earnings announcements, mergers, everything. Another way is to look at the performance of active managers. They tout themselves as people who have information that’s not in the prices. Well, you can test that. Testing investment performance is basically testing market efficiency.
FEN: When is the market likely to be inefficient or to misprice securities?
EF: When it’s closed, I guess.
FEN: What about smaller, illiquid stocks?
EF: That’s what people claim – that smaller stocks are not priced as efficiently as bigger stocks, that emerging markets are not priced as efficiently as developed markets. But anyone who looks at it empirically can’t find any evidence to that effect.
Posted by jp at November 3, 2006 2:04 PM
I have gone back and forth over the years on whether I believe in the EMH, finally settling on the view that market are efficient most of the time, but that select investors can beat the market through their security picking acumen. The problem with the type indexing most investors engage in is that overvauled as well as undervalued stocks are included in the index, thus mitigating the potential for uncovering market anomalies. However, that is beginning to change as indexing becomes more specified.
Posted by: David Hopkins at November 6, 2006 4:36 PM