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Tuesday 8 July 2014

SCOTUS Breaches the Efficient Frontier

Back to the Future

As you'll know the Psy-Fi Blog spends a lot of time pointing out to a (largely disinterested) audience of investors that there's a huge amount of psychological research out there that we can use to guide our investing behavior. In fact there are vast reams of the stuff, far too much for me to ever even summarize, let alone analyse. But as we saw in Behavioral Law and Disorder the Supreme Court, like most investors, has failed to take account of this by requiring investment professionals to benchmark themselves against the Efficient Markets Hypothesis, a failed meme if there ever was one.

Well, no more. The Supreme Court of the United States (aka SCOTUS) has donned kipper ties and white suits and boogied into the late-mid-twentieth century with a ruling that markets can no longer be regarded as entirely efficient. Somewhat surprisingly, however, the justices have based their findings not on the wealth of research that's accumulated over half a century but on an op-ed piece in the New York Times. It makes you wonder why you bother.

Junk Theory

Earlier this year the Nobel Prize for Economics was shared between three illustrious economists - Eugene Fama, Lars Peter Hansen and Robert Shiller - for "their empirical analysis of asset prices". What makes this slightly odd is that Fama is one of the architects of efficient markets theory while Shiller is a behavioral economist who's spent most of his career politely pointing out that the theory is junk. Admittedly he doesn't quite put it like that, but it's clearly the crux of his argument.

Anyway, a number of commentators have pointed out that this was a bit of an odd choice by the Nobel committee, but the committee members are all quite old and it's a nice prize and a lot of money so everyone's generally been quite cool about it. That was up until Shiller wrote his NYT piece, Sharing Nobel Honors, and Agreeing to Disagree. The broad thrust is that his work in behavioral economics and Fama's on efficient markets isn't compatible, and if you believe both you probably believe in other economic fictions like the ideas that central bankers know what they're doing and investment analysts can predict the future:
"Market prices are esteemed as if they were oracles. This view grew to dominate much professional thinking in economics, and its implications are dangerous. It is a substantial reason for the economic crisis we have been stuck in for the past five years, for it led authorities in the United States and elsewhere to be complacent about asset mispricing, about growing leverage in financial markets and about the instability of the global system. In fact, markets are not perfect, and really need regulation, much more than Professor Fama’s theories would allow"

Professor Shiller's point is that if behavioral economics is right, and people don't behave as perfect calculating machines then markets can't be efficient. If markets aren't efficient then they can't instantaneously reflect all known information in market prices, and markets will be driven by investor sentiment as well as rational analysis. Which is really all very uncontroversial and the Supreme Court has, in its somewhat delayed wisdom, taken this on-board in the judgement in question in Haliburton Co. Et Al. v Erica P. John Fund Inc.

Now that judgement is interesting because what it allows is for corporations to mount a defense against publishing deliberately misleading information. In the past the assumption was that efficient markets would automatically take account of this information leading to mispricing and losses for investors. (Of course, a similar issue applies to misinformation that leads to gains for investors but oddly enough no one ever sues over that). Now, the justices have ruled, it's no longer possible to assume that misinformation will lead to mispricing because inefficient markets won't necessarily take the information on-board.

Which rather oddly means that it's harder to sue firms for malpractice on the grounds that although they may well have been lying through their teeth it's simply not possible to definitively state that this will lead to investors losing money. It may just be coincidence, or noise traders getting all excited over a golden cross riding on an Elliot wave with a candlestick in the conservatory. Or something.

Shareholder Value

Despite this, the ruling is good news for investors and probably for citizens of the free world. It is a chink in the armor of the economics approach that dominates every aspect of our world. Take, for example, the hated idea of financialization that I discussed in Screwed: Fictional Profits, False Accounting and Financialization. This concept demands that we apply the rules of economics to factors that are outside its dominion which leads to some very perverse behavior,

For example, in order to decide whether we should save some fish or give people access to water we need to calculate the value of water - a debate I examined in Economic Value in Aitch-Two-Oh. And we calculate this by figuring out the dollar value of fish and water: we financialize them, even though they're not really things whose value you can quantify. Well, not unless you kill the fish and sell them, which would certainly end the debate but would rather miss the point.

The ways in which economic theory has insinuated itself into every nook and cranny of our world are too numerous to enumerate. When you look it's everywhere. People calmly accept losing their jobs because they acknowledge that the main function of a corporation is to maximize shareholder value. Only that's not the main function of a corporation, it's a "fact" contingent only on a long line of economic assumptions that leads to business leaders being remunerated at a level that is simply obscene and to employees operating on a fire and forget basis.

The Men With the Golden Guns

Don't get me wrong: I think anyone who builds a business from scratch and becomes filthy rich in doing so is entitled to every penny. But I also think that corporate managers who scratch and claw their way to the top of organizations are simply hired guns in expensive suits. Pay them well, pay them very well, but don't treat them like demigods. In what possible world can we justify paying a lifer CEO 331 times the salary of an average employee? (Up-to-date figures available at Executive Paywatch).

In a world managed by the dead hand of economics, that's where.

And the most visible sign of this dead hand is the failed meme of the efficient market, a meme that has until now been supported by our legal system. This has led, to amongst other things, fiduciaries being forced to benchmark themselves against efficient markets in order to have a defence against being sued. Now, potentially, we can start to look for better ways of handling financial advice, because that ruling can no longer hold. You can't have the Supreme Court agreeing that markets aren't efficient and then upholding decisions that require advisers to assume they are efficient.

Fiduciary Opportunities

So the ruling opens the door for proper financial advice by advisers fulfilling the proper role of a fiduciary. And we can set some very simple guidelines for these advisers: diversify sensibly, don't trade very often and don't speculate on the short-term movements of assets. We can also suggest sensible behavioral rules - look for mis-pricing after corporations make surprise announcements, look for pricing anomalies when corporations announce upgrades, don't follow the herd when prices clearly get out of kilter with reality, and so on and so-forth. 

The fact that most investors and even most economists recognize that the efficient markets meme has failed doesn't mean that it doesn't still dominate the practical world of politics and finance. It's an idea enshrined in institutions and governed by law. But now, finally, we have a crack in the edifice. As that arch proponent of realpolitick, Winston Churchill once put it:
"Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning"
P.S. Technically, of course, the "Efficient Frontier" is a concept arising from modern portfolio theory as described in Markowitz's Portfolio Theory and the Efficient Frontier. In case anyone was wondering ...


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