Fama, Thaler and the ordinary investor

Today's WSJ summarizes the debate between Thaler, a leading skeptic of market efficiency, and Fama, the leading defending of the efficient capital markets hypothesis. As the article notes, the debate could have implications for privatizing social security. It quotes Thaler as saying, "[i]f you give people 456 mutual funds to choose from, they're not going to make great choices." The result may be that the securities markets get detached from fundamental values and misallocate resources.

Thaler concedes that "it is not easy to beat the market, and most people don't." This is an important point, since it follows that we have no alternative to accepting the wisdom of markets, even if it's imperfect.

But even if we can't beat the market, we should be concerned if the market is detached from real values, because then investment dollars would be misallocated. On this point Thaler has little doubt, saying that Fama "is the only guy on earth who doesn't think there was a bubble in Nasdaq in 2000." In fact, Fama's not alone, as I've noted.

Assuming markets are inefficient in the weaker sense just noted, what should we do about it? Those who align with Thaler suggest that privatizing social security would further misalign securities prices from value by bringing more irrational investors into the market. The WSJ says that "in a rational world, share prices should move only when new information hit the market. But with more than one billion shares a day changing hands on the New York Stock Exchange, the market appears overrun with traders making bets all the time."

My main point here is that this conclusion, if true, has implications beyond social security. As I've noted, our securities laws are based on the principle that markets should be safe for ordinary investors. If we're really concerned about a lot of irrational investors running around, then we should be skeptical not only about privatizing social security, but about the securities laws as well. This would mean drastic revisions of disclosure rules, and being honest with investors and voters about what the securities laws are able to accomplish. Investors are either rational or irrational. Public policy should follow logically and consistently from whichever conclusion we choose to accept.

Comments

[Eric Yang]

People only realize the irrationality of their behavior after fact, but when there is enough unknown regarding the potential and caveats of something new, commercialized Internet for example, those stupid investments did buy valuable knowledge of what works and what does not. And with more money people reached those knowledge very quickly, and that has its intrinsic value don't you think?

[Robert Schwartz]

The securities laws are kind of a bad joke.

Investors get handed a couple of hundred pages of unreadable glub and are told that it puts them on the same plane as market professionals and company insiders. It might be if they had the time and skill to read and interpret the garbage, but they don't.

The system is set up to protect the brokerages and their commissioned salesmen from the anger of the customers that they regularly fleece by deflecting the responsibilities of the brokers, as market professionals, on to the issuers, who are not innocent, but who are not equipped to baby-sit the investors.

Real reform would involve, aboliton of the commissioned salesmen, increasing the fiduciary responsibility of the brokers, replacing industry arbitration with a system run by non-profit neutrals, and repealing SOX.

[Ann]

I don't think that people are "either rational or irrational". A better way to look at it is that, when they have poor information and/or when there is a cost to processing information, people sometimes take shortcuts or make systematic errors. But this doesn't mean that government bureaucrats should decide who is and isn't allowed to participate in markets.

A better approach is to look for ways to improve information and to give participants better incentives, not to try to label some as rational and others (or all) as irrational. We've all made mistakes, so I guess that, in that sense, we're all "irrational" - perhaps all humans should be banned from "the market"?

The WSJ quote about markets moving only when there is new information is focusing on a very narrow definition of "information". We're talking about forecasts of the future. People may revise their forecast at any time.

I'd like to hear more about what you're suggesting on disclosure (do you want more or less of it?) and on being honest with people about securities laws. What is it that we're not telling people about securities laws now? Surely no one believes currently that securities markets are strong-form efficient. And yet, we haven't found an alternative that consistently outperforms.

[Ann]

I just went back and read your earlier post on whether small retail investors should have a major role in the price-setting process for IPOs, as with Google and other auctions. IPO auctions have been tried around the world, and they've failed everywhere, precisely because the price-setting process was left to small retail investors. Are investors irrational and incapable of figuring out a good price? No, but they probably don't have the training or resources, and they definitely don't have an incentive to put in a lot of time and effort in a "Dutch" auction.

I strongly agree that handing small investors a major role in pricing securities as difficult as IPOs is a bad idea, not because investors are irrational but because they're rational enough to figure out their optimal strategy. And the optimal strategy in Google's auction was NOT to put huge amounts of time and effort into "doing their homework" before they placed their bid.

The SEC's problem with trying to apply Efficient Markets theory in practice is the implicit assumption of endowed information. If people woke up one morning knowing, to the second decimal place, the exact value of Google to them, they would be rational enough to place a reasonable bid. The problem is that valuable information doesn't magically appear. Valuing securities is hard work, and people won't do that hard work unless they expect to be rewarded for it. Anyone who has taught students knows that if you give them a choice - do your own homework or take a shortcut - at least some students will take the shortcut, because they're "rational" enough to realize that it's easier. "Dutch" IPO auctions favor people who copy their answers from someone else, rather than those that do their own homework, and that's why they've failed in so many countries.