The Efficient Market Hypothesists

The Efficient Market Hypothesists

Great Minds in Finance Series Editor: Professor Colin Read This series explores the lives and times, theories and applications of those who have contributed most significantly to the formal study of finance. It aims to bring to life the theories that are the foundation of modern finance, by examining them within the context of the historical backdrop and the life stories and characters of the great minds behind them. Readers may be those interested in the fundamental underpinnings of our stock and bond markets; college students who want to delve into the significance behind the theories; or experts who constantly look for ways to more clearly understand what they do, so they can better relate to their clients and communities. Titles include: THE LIFE CYCLISTS THE PORTFOLIO THEORISTS THE RISE OF THE QUANTS THE EFFICIENT MARKET HYPOTHESISTS

The Efficient Market Hypothesists Bachelier, Samuelson, Fama, Ross, Tobin, and Shiller Colin Read

Colin Read 2013 Softcover reprint of the hardcover 1st edition 2013 978-0-230-27421-1 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6 10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2013 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-1-349-32435-4 ISBN 978-1-137-29221-6 (ebook) DOI 10.1057/9781137292216 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 22 21 20 19 18 17 16 15 14 13

Contents List of Figures Preface to the Great Minds in Finance series vii viii 1 Introduction 1 Section 1 Louis Bachelier: The First Physicist Financial Theorist 2 The Early Years 7 3 The Times 14 4 The Theory 24 5 Discussion and Applications: Einstein and Bachelier 33 6 Life and Legacy 44 Section 2 Paul Samuelson s Random Walk 7 The Early Years 55 8 The Times 65 9 The Theory 75 10 Discussion and Applications 82 11 The Nobel Prize, Life, and Legacy 87 Section 3 Eugene Fama s Efficient Market Hypothesis 12 The Early Years 93 13 The Times 98 14 The Theory 102 15 Discussion and Applications 107 16 Life and Legacy 116 Section 4 Stephen Ross and Arbitrage Pricing Theory 17 The Early Years 121 18 The Times 128 19 The Theory 130 20 Discussion and Applications 134 21 Life and Legacy 139 v

vi Contents Section 5 James Tobin and a New Policy 22 The Early Years 147 23 The Times 153 24 Tobin s Efficient Market Paradigm 158 25 Discussion and Applications 163 26 The Nobel Prize, Life, and Legacy 170 Section 6 Robert Shiller and Irrational Exuberance 27 The Early Years 177 28 The Times 184 29 The Theory 189 30 Discussion and Applications 193 31 Life and Legacy 195 Section 7 What We Have Learned 32 Combined Contributions 201 33 Conclusions 205 Glossary 207 Notes 213 Index 219

List of Figures 2.1 The family tree of Louis Bachelier (1870 1946) 8 7.1 The family tree of Paul Samuelson (1915 2009) 57 7.2 The family tree of Marion Crawford (1916 1978) 63 12.1 The family tree of Eugene Fama (1939 ) 94 17.1 The family tree of Stephen Ross (1944 ) 123 17.2 The family tree of Carol Frost (1944 ) 125 22.1 The family tree of James Tobin (1928 2002) 148 27.1 The family tree of Robert Shiller (1946 ) 179 27.2 The family tree of Virginia Marie (Faulstich) Shiller 182 vii

Preface to the Great Minds in Finance series This series covers the gamut of the study of finance from the significance of financial decisions over time and through the cycle of one s life to the ways in which investors balance reward and risk; from how the price of a security is determined to whether these prices properly reflect all available information we will look at the fundamental questions and answers in finance. We delve into theories that govern personal decision-making, those that dictate the decisions of corporations and other similar entities, and the public finance of government. This will be done by looking at the lives and contributions of the key players upon whose shoulders the discipline rests. By focusing on the great minds in finance, we draw together the concepts that have stood the test of time and have proven themselves to reveal something about the way humans make financial decisions. These principles, which have flowed from individuals, many of whom have been awarded the Nobel Memorial Prize in Economics for their insights (or perhaps shall be awarded some day), allow us to see the financial forest for the trees. The insights of these contributors to finance arose because these great minds were uniquely able to glimpse a familiar problem through a wider lens. From the greater insights provided by a more expansive view, they were able to focus upon details that have eluded previous scholars. Their unique perspectives provided new insights that are the measure of their genius. The giants who have produced the theories and concepts that drive financial fundamentals share one important characteristic: they have developed insights that explain how markets can be used or tailored to create a more efficient economy. The approach taken is one taught in our finance programs and practiced by fundamentals analysts. We present theories to enrich and motivate our financial understanding. This approach is in contrast to the tools of technicians formulated solely on capitalizing on market inefficiencies without delving too deeply into the very meaning of efficiency in the first place. From a strictly aesthetic perspective, one cannot entirely condemn the tug-of-war of profits sought by the technicians, even if they do little to enhance and may even detract from efficiency. The mathematics and physics of price movements and the sophistication of computer algorithms is fascinating in its own right. Indeed, my appreciation for viii

Preface to the Great Minds in Finance series ix technical analysis came from my university studies toward a Bachelor of Science degree in physics, followed immediately by a PhD in economics. However, as I began to teach economics and finance, I realized that the analytic tools of physics that so pervaded modern economics have strayed too far from explaining this important dimension of human financial decision-making. To better understand the interplay between the scientific method, economics, human behavior, and public policy, I continued with my studies toward a Master of Accountancy in taxation, an MBA, and a Juris Doctor of Law. As I taught the economics of intertemporal choice, the role of money and financial instruments, and the structure of the banking and financial intermediaries, I recognized that my students had become increasingly fascinated with investment banking and Wall Street. Meanwhile, the developed world experienced the most significant breakdown of financial markets in almost eight decades. I realized that this once-in-a-lifetime global financial meltdown arose because we had moved from an economy that produced things to one in which, by 2006, generated a third of all profits in financial markets, with little to show but pieces of paper representing wealth that had value only if some stood ready to purchase them. I decided to shift my research from academic research in esoteric fields of economics and finance and toward the contribution to a better understanding of markets by the educated public. I began to write a regular business column and a book that documented the unraveling of the Great Recession. The book, entitled Global Financial Meltdown: How We Can Avoid the Next Economic Crisis, described the events that gave rise to the most significant economic crisis in our lifetime. I followed that book with The Fear Factor, which explained the important role of fear as a sometimes constructive and at other times destructive influence in our financial decision-making. I then wrote a book on why many economies at first thrive and then struggle to survive in The Rise and Fall of an Economic Empire. Throughout, I try to impart to you, the educated reader, the intuition and the understanding that would, at least, help you to make informed decisions in increasingly volatile global economies and financial markets. As I describe the theories that form the foundations of modern finance, I show how individuals born without great fanfare can come to be regarded as geniuses within their own lifetime. The lives of each of the individuals examined in this series became extraordinary, not because they made an unfathomable leap in our understanding, but rather because they looked at something in a different way and caused us all thereafter to look at the problem in this new way. That is the test of genius.