Andrew Shleiffer's Inefficient Markets
A Review by Eric Falkenstein
In 1951 George Stigler noted "each decade, for the past nine or ten decades, economists have read widely in the then-current psychological literature. These explorers have published their findings, and others in the field have found them wanting—wanting in useful hypotheses about economic behavior." Fifty years later, the latest aspiring psychonomic founding father puts forth his case.
Professor Shleifer, the latest winner of the John Bates Clark award for outstanding economist under 40, has collected his papers from a set of Clarendon lectures given at Oxford in 1996. It is a coherent set of arguments that tries to both demonstrate and explain why we should reject the efficient markets hypothesis, and why these "behavioral" models can explain many interesting phenomena, like closed-fund discounts and strategies behind seasoned equity offerings. If one is interested in behavioral finance, this is a theory-focused, succinct and comprehensive place to start.
Literature Review and Context
Irrationality and market inefficiency are not new topics. My favorite exposition of the two views within finance—rational markets vs. animal spirits—is Malkiel’s A Random Walk Down Wall Street (1973, 1999), which through revisions has not lost relevance and puts the debate into a very broad historical overview. More technical reviews of the literature are contained in Steven LeRoy’s 1989 Journal of Economic Literature article ‘Efficient Capital Markets and Martingales’, and more recently Eugene Fama’s 1998 Journal of Financial Economics article ‘Market Efficiency, long-term returns, and behavioral finance.’
While market inefficiency is an old topic, its popularity as applied to financial markets has grown substantially over the past 20 years. Given limitations of the traditional paradigm to explain so much observed behavior (e.g., why are there small-cap growth funds?) and the conspicuous empirical failure of CAPM, this is to be expected. For example in February 2001 the New York Times had not one but two articles by different authors on behavioral economics, making it officially trendy. This is good news for everyone researching in this area, in that the last thing a researcher wants is for his field to simply become uninteresting (e.g., quantity theory of money). For a journalist the story is familiar: a stolid conventional wisdom experiences a Kuhnian shift, lead by a small band of outsiders willing to flout traditional ways. The behavioralists reject "the narrow, mechanical homo economicus" and instead argue that " that most people actually behave like . . . people!" The other NYT piece offers a similar slant, with an article titled "Some Economists [the behavioralists] Call Behavior a Key", implying that previously economists never were concerned with preferences or rationality. Clearly we could use some counterbalance to such irrational exuberance, and Shleifer delivers.
For a long time debates about irrationality were cut short by Friedman’s argument that irrational or inefficient speculators will tend to lose money, giving irrational traders a short enough half-life to make them irrelevant. Combined with the observation that most mutual fund managers do not outperform passive benchmarks, and Samuelson’s (1965) application of the law of iterated expectations to give understanding to Bachelier’s (1900) observation that securities prices look like a random walk, and we had both elegant theory and voluminous evidence. The efficient markets theory reached its current plateau in 1970 with Fama's articulation of what efficient markets mean, establishing and official paradigm, the efficient markets hypothesis (hereafter EMH). Cracks in the edifice have occurred since creation, but invariably each crack is spackled. Consider the empirical findings of Shiller (1980), DeBondt and Thaler (1985,1987), Lo (1990), and the theoretical papers of Grossman and Stiglitz (1980). Shiller was countered by Kleidon (1986), Grossman and Stiglitz, rather than destroying the concept of efficiency morphed into an elegant literature on how efficient markets incorporate diverse information into prices. Conrad and Kaul (1993) documented that much of DeBondt and Thaler result was due to simple measurement error. Lo (1999) provocatively titles his book, but in general his deviations from rationality are subtle.
Other events have helped solidify the EMH. Most prominently, fund managers continue to underperform passive indices. Further, for a long time Mackay (1841), Galbraith (1954), and Kindelberger (1978) gave us our understanding of the Dutch Tulip Bubble and the Great Crash of 1929, clear examples of irrationality run amok. Garber (1989) and White (1990) created new interpretations that showed that these episodes might have contained some unwarranted exuberance, but were not as patently irrational as once thought. Also, while the 1987 stock market crash was originally considered a huge blow to efficient markets, in my opinion it helped bolster the EMH by proving that market declines didn’t automatically cause recessions; the negative effects of endogenous deviations from fundamental value were not as great as once thought (previously it was assumed there was a major cause-and-effect relation between the market crash of 1929 and the Great Depression).
Finally, consider the discovery and then disappearance of numerous CAPM anomalies. There have been the January effect, the Monday effect, the end-of-the-month effect, and others, which are now orphans in the literature. However, the small firm effect and the value effect are still somewhat living embarrassments. Once Banz (1981) discovered the small firm effect and subsequent research showed that it persisted in the historical data even after methodological adjustments (though recent work by Shumway and Warther (1999) puts even this into doubt), many people tried to use this ‘fact’ as a basis for theories, both rational and irrational (Fama and French, 1993). Unfortunately, it disappeared immediately after discovery, which has lead to a steady decline in papers 'explaining' why this fact occurs (see chart of size effect's disappearance). The other major statistical anomaly, the value effect, fit extremely well into behavioralist theory (Lakonishok, Shleifer and Vishny, 1994). Here again, once recognized as not a fluke but a fact worth explaining, it subsequently disappeared in the US (see chart of value effect's disappearance). For these reasons I consider the EMH bloody but unbowed.
While I am in general skeptical of much of the behavioralist research agenda, I find their practical focus a nice counterbalance to the patently incomplete classical theory of investments as described in the textbooks of Huang and Litzenberg (1988) or Ingersoll (1987). I remember learning in my PhD investments class that one of the CAPM corollaries is that there should only be one mutual fund in equilibrium, basically one passive index fund. Clearly there is a disconnect with a world where there are more funds than stocks, but no one seemed to let the facts diminish enthusiasm for further work in the field. A PhD’s general investment advice could use an understanding of the behavioralist issues if for no other reason than forcing them to read and think about real investment strategies, as opposed to simply thinking that the only practical investment advice is to diversify (buy the market) and choose one’s risk tolerance (decide how much to allocate to the market).
Economists have a long history of criticizing established theory, especially those who see problems with free markets (e.g., Marx, Keynes). The problem, however, is that while existing theory is invariably an oversimplification, alternatives that once seemed obvious end up proving themselves to be no better, even if they contained some kernels of truth (e.g., Marx, Keynes). The behavioralist agenda is filled with kernels of truth, but should these be best thought of as exceptions within the rational paradigm, or the basis for a new paradigm? Should every paper have a proper reference to Khaneman and Tversky? An incomplete listing of the behavioral finance agenda includes prospect theory, regret and cognitive dissonance, anchoring, mental compartments, overconfidence, over- and underreaction, representativeness heuristic, and the availability heuristic. Fama (1998) has rightly put the behavioral paradigm on the defensive by noting that about half of the published empirical anomalies appear to be overreaction and half underreaction, pretty much what one would expect given many researchers mining for publishable exceptions to an efficient markets rule.
Chapter 1 lays out the two pillars to his argument: a theory of investor sentiment, and limits to arbitrage. Both are needed, as without systematic deviations from rationality, irrational decisions cancel each other out, making them somewhat uninteresting (excepting increasing volume); without limits to arbitrage such irrational deviations from ‘true value’ are instantly poached by savvy rational investors.
Interestingly, Shleifer highlights DeBondt and Thaler’s 1985 paper on going long past losers and short past winners as empirical proof of overreaction. I found Conrad and Kaul’s (1993) demonstration that this was purely the result of a methodological error rather conclusive. This is made even more convincing by the fact that if the result could withstand measurement adjustments and persisted we should have seen these results updated—we haven’t. In contrast, there is the definitive example of the difference in price between Dutch and Royal Shell on two separate exchanges. These different listings by law apportion a 60:40 split of cash flows and thus should trade as such, but indeed they vary by as much as 30% from this fundamental equivalence. Shleifer calls this a ‘fantastic embarrassment’ to the efficient markets hypothesis (Wall Street Journal, 12/28/00). This example is so much more compelling because it is almost impossible to prove that Amazon.com, for example, was ever priced too high because it depends on an uncertain future (see Kleidon or Garber). However in the Shell example it is different prices for the same thing at one point in time--like 16 oz ketchup differing from the sum of two 8 oz bottles of ketchup. If true value is a only one value (though known only to God), this seems like a clear violation of the law of one price.
The first model shows that if arbitrage is limited and noise traders have systematic biases, prices can deviate from fundamental value (DeLong et al, 1990a). That is, Shell can deviate because no one has enough money and time to put the two prices into their accounting equilibrium, and investor sentiment varies between the two markets. This model also has the interesting implication that less informed investors might earn a higher rate of return on their total portfolios because they irrationally believe they have a more favorable risk-return opportunity and hence invest in securities with a higher return. In effect, their stupidity effectively diminishes their risk aversion, and in the long run allows a lucky few of them to reap the financial rewards that would accrue to the less risk averse (one could call it the ‘Forrest Gump’ effect). As opposed to speculation weeding out the irrational traders and making only the best opinions matter, the irrational can dominate.
The closed fund puzzle is presented in chapter three and highlights some of the problems of this approach (Lee, Thaler and Shleifer, 1991). The issue to be explained is why 1) funds are issued at premiums to net asset value (overpriced) and 2) funds eventually trade at discount to net asset value (underpriced). While the underpricing is addressed through the mechanism outlined in the first model (limited arbitrage and noise traders), the overpricing effect is addressed by assuming that ‘noise traders’ buy up the initial issuance—not very subtle. Clearly if noise traders can be foisted into overpaying or underpaying within models by assumption, it is hard to avoid the inference that this approach can explain everything and thus nothing.
Of course on occasion EMH proponents also try to explain seemingly everything, where exceptions are assumed order-statistics until they are granted statistical significance, at which time they are instantly seen as efficiently proxying immeasurable risk (e.g., the value and size effect). Yet overreaching is clearly more of a problem to the inefficient markets camp. For example, in addition to the above example, investor sentiment is used to explain both the equity-premium puzzle (i.e., why stock prices are too low on average) and why recent p/e multiples are too high (page 180): if the equity-premium is a ‘puzzle’ it is difficult to also say that our currently historically high p/e multiple is irrational, but if the p/e ratio ‘should’ be lower (around 15) then the equity premium is not a puzzle. No theory can try to explain everything and remain useful (e.g., Freudian psychology).
In chapter 4 a nice approach is taken towards professional arbitrage (Shleifer and Vishny, 1997). By modeling it as a principal agent problem, this model captures some relevant issues usually addressed by the Industrial Organization literature. Clearly there is relevance to modeling the situation where hedge fund managers have uncertain skill and investors have to evaluate them. The failure of famed hedge fund LTCM in 1998 was defended, like almost all bankruptcies, as a failure of investor’s patience--outsiders are always much quicker at pulling the plug than insiders would prefer. Modeling, in this case, a liquidity constraint, is a highly relevant issue that seems well suited for asymmetric information and principal-agent modeling.
Chapter 5 introduces the model of investor sentiment, that is, why we should expect noise traders to vary systematically in their buy or sell orders (Barberis, Shleifer, and Vishny, 1998). It derives a straightforward and testable hypothesis based on Bayesian updating of a regime-switching model. For earnings or other surprises that continue a trend, overreaction is predicted, for surprises that counter a trend, underreaction is predicted. Clearly this is what this paradigm needs, a testable, pervasive and important empirical effect.
In chapter 6, we see the DeLong, Shleifer, Summers, and Waldeman series on noise traders and positive feedback loops (DSSW, 1990b). This sort of model bothers me because it is a bit disingenuous. It puts superficial rigor onto to the simple idea that “given constraints on arbitrage, irrational trend-following investors can make it rational to follow trends, and thus rational traders can be destabilizing.” It is not a compelling model because the results are not derived inevitably and subtly from general assumptions and a friction, but instead from assumptions which guarantee the result (e.g., trend-following noise traders and limited arbitrage). Is it at all helpful to take a straightforward idea that can be clearly expressed in a sentence and model this algebraically? Personally I do not think so, though the realist in me understands that without a model to point to, the idea would not be taken as seriously as it has.
It is stressed throughout the book that risky arbitrage makes taking advantage of pervasive irrationality difficult. Yet if irrationality is a systemic and pervasive phenomenon, then there exist hundreds of scenarios like mispriced Shell, overvalued Amazon, undepriced closed funds, overvalued currencies, overvalued IPOs, etc. Surely over several years these positions, somewhat independent, should make significant abnormal risk-adjusted returns. As is more probable, there are not hundreds of such situations, but perhaps a handful, and with the rational markets assumption ignored hundreds more opportunities appear to exist but actually do not (e.g., the small firm effect). I do not see how the risky arbitrage argument, as applied to individual situations, can avoid the implication that if it is pervasive and not simply a limited set of anomalies to the EMH, behavioralist hedge funds should dominate their peers.
Deviations from Fundamental Value
Fundamentally I see the concept of ‘true value’ itself to create a counterproductive behavioralist preoccupation with rejecting the EMH. Shleifer’s ‘gotcha’ argument is that, as with the Shell scenario, true value does not always match its market price, though usually not so great as to allow riskless profit opportunities. If prices do not vary so much as to allow one to make money, but diverge sufficiently from some benchmark, are these deviations material? This may seem like a semantic issue, but it is real, as both Malkiel and Shleifer pointed to the Shell example in a recent Wall Street Journal point/counterpoint debate.
Shleifer once wrote that “[i]f the efficient markets hypothesis was a publicly traded security, its price would be enormously volatile"—too volatile, supposedly (Shleifer and Summers, 1990). Presumably Shleifer thinks that economists are rational and understands that the rational consensus around a proposition can and does vary wildly around the truth, so why can’t market participants also be considered rational and yet have their collective opinions vary wildly over time and space? Truth is a very slippery concept, and whatever it may be for various propositions, it is something reasonable people can often agree to disagree, in aggregate and at different times. This violates economist’s conception of Common Knowledge (Aumann, 1987), but do we really believe in the assumption of these models, that every agent ‘knows what they know’ ad infinitum? Unlike derivatives which have true prices predicated on other prices, what determines the true value of Shell? Clearly for one exchange only one price is possible, but for two exchanges that for various reasons restrict arbitrage, what is so ‘fantastically embarrassing’ to the EMH that there exist two prices, close, but not exactly the same? In the sense of Friedman, markets usually behave as if true value was determined rationally and as if true value was equal to its ex ante discounted present value. Until a specific alternative proves more robust, the rationality assumption generates too much explanation in a simple way to discard for the current, ill-specified behavioralist agenda.
Respect for the Real Rebels of Finance
To me, market efficiency in practice is best exampled by the appearance and disappearance of the ‘convexity bias’ between swap forwards and Eurodollar futures. The arbitrage worked like this. If future and forward rates were equivalent, one could go long swaps (forwards) with short Eurodollars (futures), and the daily mark-to-market of the Eurodollars vs. the future mark-to-market of the swap would allow one to lock in a sure thing. The mechanism underlying this opportunity was subtle, but the effect added up to 15 basis points in present value if done with 5-year swaps. Some traders knew about this for years, and it was written up in RISK magazine in 1990 (Rombach, 1990). A some years later it disappeared, after which academic economists wrote about it in the Journal of Finance (Grinblatt and Jegadeesh, 1996). Nonrisky profit opportunities such as these do exist, and they don’t disappear immediately, but they do go away eventually, usually well before academics have discovered them. Shleifer would see this as a fantastic embarrassment, while Fama would probably see it as inconclusive based on the poor power to reject some unspecified rational model. I see it as disequilibrium phenomenon, a temporary aberration that is of interest only to those lucky few who identified it while it still conferred a profitable opportunity. Disequilibrium behavior has always been difficult for economists to explain, as all such activities are idiosyncratic or ephemeral.
Those in favor of Tobin taxes, pegged exchange rates and market meddling of various sorts often point to the results of the behavioralist cadre for support. George Soros, the original poster boy for the DeLong et al noise trader thread, now vehemently disagrees with Shleifer and serially proposes radical new theories and remedies to financial markets. Once outside the rational markets paradigm this is what one should expect (Soros, 1987, 1998, 2000). When one combines these consequences to Shleifer’s latest plea that he still thinks that “the market knows better than the government” (WSJ, 12/28/00) one is reminded of political education of another John Bates Clark winner and now New York Times pundit Paul Krugman. To review, in Krugman’s early work he developed very clever game-theoretical scenarios in which free trade actually made a country worse off. These were improbable but theoretical exceptions to the rule, but then Krugman was fighting the seemingly simple-minded and oppressive economic dogma that free trade is always a win-win proposition. Now Krugman, an otherwise tax-spend-and-regulate liberal, finds himself defending free trade more often than not, having found that those who would use his result focused only on the ‘proof’ against free trade, as opposed to its much more qualified statement (Krugman, 1995). For academics, the enemy of their enemy is rarely their friend.
The behavioralists like to portray themselves as rebels, Davids versus the theoretical Goliath, but in reality the efficient markets folks deserve the true rebel status. Almost everyone outside this literature is sympathetic to behavioral theories over the rational markets assumption, regardless of one’s political bent. I used to work for a bank where our swap salesmen could always sell swaps to companies by telling their treasurers how these instruments could make money given their idiosyncratic view of the market. To these teasurer's detriment very few of them had an EMH prejudice (“perhaps the forward prices and their implied volatilities are as good a forecast as mine, and so including commission this is a negative-sum speculation!”) For noneconomists, nothing epitomizes the irrationality of economists so much as their rationality assumption. One doesn’t have to laugh and cry reading Dilbert to know that there are lots of irrational business people, and that many business decisions are made by former B- students who are both boundedly rational and internally inconsistent. The real question is whether or not these irrational actions generate useful hypotheses about economic behavior, and thus far most of these predictable actions relate to volume and volatility. The over and underreaction hypotheses seem about as promising as the adaptive expectations assumption that underlies it, and Keynesians worked with that for years without bearing fruit.
The behavioralists are focused on truly relevant issues, but this is not sufficient for making it a success. While I am encouraged with the piecemeal usage of behavioralist findings (e.g., Shleifer and Vishny (1997), Odean (1998), Daniel et al (2000), Hong and Stein (1999)), in general this line of research needs more discipline, discipline provided by the very paradigm so many prominent behavioralists are fond of trashing. 'Rejecting efficient markets’ is not a necessary or even helpful pillar to understanding current anomalies because it is difficult to see any comparable replacement that would prevent the field from turning into chaos, where every outcome is the result of some ad hoc noise trader assumption. The efficient markets paradigm is a triumph of economics because it is so counterintuitive to the layman, so restrictive in what it allows, and so pervasive in its application. A healthy respect for the rationality of markets is a hugely advantageous mindset for the researcher and practitioner. This should be the base from which one identifies anomalies, and then explains them with specific frictions or cognitive biases.
I should mention that my profession of the last several years has been to violate efficient markets.
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