The Fallibility of Efficient Markets Theory
It’s long past time for professional investors to set aside the efficient market hypothesis (EMH) as the basis of most asset management strategies, according to Paul Woolley, a senior fellow at the London School of Economic and Political Science. Noting that earlier, on the first day of the Sixth Annual European Investment Conference, keynote speaker Martin Wheatley had discussed ethics, trust, and governance, Woolley dismissed those issues as secondary to the primary problem — the intellectual framework in which finance is conducted. “I blame the academic theory of efficient markets for the successive crises we’ve had,” Woolley said.
The EMH, he said, assumes that competition results in asset prices that reflect fair value and self-stabilizing capital markets, allowing no room for excess returns for intermediaries. Further, it does not address what Woolley called the “three perversities of investing”: momentum, short-termism, and risk-return inversion. The way forward, according to Woolley, is an asset pricing model that recognizes that investors delegate to agents, and these intermediaries have different degrees of competence and different objectives. This leads to asset mispricing and “rent capture” by agents.