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The Efficient Market Hypothesis and its Critics

Burton G. Malkiel, the Chemical Bank Chairman’s Professor of Economics at Princeton University, delivered the John M. Olin Lecture in Law & Economics on Thursday, November 1 in Caplin Pavilion on the topic “The Efficient Market Hypothesis and its Critics.” Malkiel is best known outside the academic world for his best-selling book, A Random Walk Down Wall Street, first published in 1973 and now in its seventh edition.

The efficient market hypothesis, Malkiel explained, refers to the notion that the prices of stocks rapidly adjust to any new information that relates to the stocks’ prospective returns. If indeed stock prices reflect all currently available information, then future price changes will reflect only future news, which is by definition unpredictable. The consequence, then, is that future stock prices should be unpredictable.

In recent years, however, a growing number of critics have argued that the efficient market hypothesis does not reflect the reality of stock price behavior. Many of these theories are based on the notion that investors do not react rationally to information, but are instead influenced by fads and other psychological phenemona. All of the theories, however, draw their motivation from apparent “anomalies” in stock price behavior that imply predictability.

Malkiel described in detail several of the best-known anomalies. For example, imagine that we divide stocks into deciles based on their dividend-to-price (D/P) ratio. Malkiel showed that in the bottom decile, the initial dividend yield is less than 2.9%, whereas in the upper decile it is greater than 6.1%. Now consider what happens if we track the performance of these ten imaginary portolios over time. Researchers have shown that over a ten-year period, the high D/P stocks outperformed the low D/P stocks—indeed, the ranking of the portfolios by 10-year return almost perfectly matched the ranking by D/P ratio. One can obtain a similar result by dividing stocks into deciles based on their initial price-to-earnings (P/E) ratio. Here, the ranking of those portfolios by subsequent 10 year returns almost perfectly matches the inverse ranking by initial P/E ratio.

This, however, implies predictability. It implies that one could earn systematically higher returns by purchasing stocks with high D/P or low P/E ratios, which in turn suggests that the current prices of stocks do not fully reflect the information contained in those ratios.

Malkiel disputed the lessons other academics have drawn from such studies in two ways. First, he noted that many of these anomalies are sensitive to the time period selected for study. If an anomaly does not persist for all time periods, however, it is impossible to tell whether it is evidence against stock market efficiency.

More tellingly, however, he argued that the ultimate test of stock market efficiency is whether these anomalies can be used to earn “abnormal” returns, that is, returns that exceed those expected. Here, he contends, the best evidence comes from those whose livelihoods depend on earning the highest possible risk-adjusted returns. Malkiel pointed to the persistent failure of the average professional mutual fund manager to earn a higher return than a broad-based index as the strongest evidence that prices are not predictable.

Even the boom and bust in internet stocks, Malkiel contends, is anomalous only with the benefit of hindsight. He noted the persistent failures of academics and professional money managers to predict with any precision the future course of internet stock prices. Malkiel concluded that the case for the efficient market hypothesis remains strong.
• Reported by M. Marshall

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