Efficient Market Discussion and Understanding of Finance

Efficient Market Discussion and Understanding of Finance

As the 2013 Nobel Laureates in economic science, both of Eugene Fama, from the University of Chicago and Robert Shiller, from Yale University, have made famous contribution to the finance world. Even though their views toward market efficiency seem mutually contradictory, their theories has been highly valued by the finance academia as well as industry. This paper compares and contrasts the work of both of them and discusses how their work influence my understanding of finance.

Fama is known for his work in initiating and developing the “efficient market hypothesis (EMH).” In his paper, Fama defines “efficient market” as “a market in which prices always fully reflect available information” (Fama 1970). If prices did reflect all available information, trading rules and fundamental analysis would not help investors to constantly earn abnormal return. This proposition has been checked by others and himself in the following papers: "Random Walks in Stock Market Prices (Fama 1965)," and "Filter Rules and Stock Market Trading Profits" (Blume, Fama 1966). Stock prices react to new information so quickly that it is almost impossible to trade on that piece of new information and profit from it. Furthermore, investors cannot earn abnormal returns without taking more systematic risk. To address the different types of information that stock prices could reflect, Fama prosed three types of market efficiency: (1) strong-form, where prices reflect all private and public information; (2) semi-strong form, where prices reflect all public information; and (3) weak-form, where prices only reflect past public information (Fama 1970). Index funds, which did not even exist fouty years ago, are now very popular among investors. Its creation was a result of Fama’s notion that actively managed fund cannot beat the market. Fama’s theory has also brought great influence to the accounting and economics academia.

The efficient markets theory dominated the finance academia in the 1970s. Starting the 1980s, the question that weather stock market is as efficient as Fama described has been asked by more and more scholars. Robert Shiller is one of leading scholars of the “behavioral finance” academia. In Shiller’s view, the stock market is inefficient in terms of reflecting all information due to human behavior. In his paper, Shiller showed “excess volatility relative to what would be predicted by the efficient markets model” (Shiller 2003). As the efficient market model cannot explain the level of volatility of the stock market, Shiller claimed that the efficient markets model was not supported by the stock market fluctuations (Shiller 2003). Instead, Shiller shows that psychology can lead to market inefficiency as people are not as rational as expected by the EMH. Shiller uses “feedback models” to explain part of the excess volatility of the stock market. In his paper, he describes the model as “when speculative prices go up, creating successes for some investors, this may attract public attention, promote word-of –mouth enthusiasm, and heighten expectations for further price increases” (Shiller 2003). Shiller also claimed that if EMH is right market crashes, such as crashes of 1987, 2002, and 2008, should not have happened this often. His introduction of psychology to finance has attracted more scholars’ attention.