The Economics Book

272

See also: Economic bubbles 98–99 ■ Testing economic theories 170 ■

Financial engineering 262–65 ■ Behavioral economics 266–69

A

commonly held belief

among investors is that

they can “beat,” or

outperform, the stock market.

The US economist Eugene Fama

disagreed. His study, Efficient

Capital Markets (1970), concluded

that it is impossible to beat the

market consistently. His theory

is now known as the efficient

market hypothesis.

Fama claimed that all investors

have access to the same publicly

available information as their rivals,

so the prices of stocks fully reflect

all the knowledge available. This is

the “efficient market.” No one can

know what new information will be

released, so it should be almost

impossible for investors to make a

profit without using information

unavailable to the competition, or

“insider trading,” which is illegal.

However, problems with the

hypothesis have been highlighted

by behavioral economists. They

point to the theory’s failure to

account for investor overconfidence

and the “herd” instinct. These

problems manifested themselves in

the Dotcom bubble of the 1990s,

where “irrational exuberance” was

blamed for artificially inflating

technology stock, and the more

recent financial crisis of 2007–08.

After these crises many

observers have declared the theory

redundant; some have even blamed

it for the crashes. Eugene Fama

himself has conceded that

uninformed investors can lead the

market astray and result in prices

becoming “somewhat irrational.” ■

PRICES TELL

YOU EVERYTHING

EFFICIENT MARKETS

IN CONTEXT

FOCUS

Markets and firms

KEY THINKER

Eugene Fama (1939 – )

BEFORE

1863 French broker Jules

Regnault publishes Playing the

Odds and the Philosophy of the

Stock Exchange, which states

that fluctuations in the stock

market cannot be predicted.

1964 US economist Paul

Cootner develops Regnault’s

ideas on fluctuating markets in

his The Random Character of

Stock Market Prices.

AFTER

1980 US economist Richard

Thaler publishes the first study

of behavioral economics.

2011 Paul Volcker, former

chairman of the US Federal

Reserve, blames an

“unjustified faith in rational

expectations and market

efficiencies” for the 2008

financial crash.

In an efficient market

at any point in time the

actual price of a security

will be a good estimate

of its intrinsic value.

Eugene Fama