OVER the last few weeks, as the stock market has reached new highs, my thoughts have turned to my 85-year-old mother.
“O.K. Mr. Smarty-Pants,” she often asks me, “what stock should I buy now?”She first asked me this question when I was an undergraduate at Princeton, majoring in economics. She asked again when I was a graduate student at M.I.T., earning a Ph.D. in economics. And she has asked it regularly during the last three decades when I have been an economics professor at Harvard.Unfortunately, she has never been happy with my answers, which are usually evasive. Nothing in the toolbox of economists makes us good stock pickers.Yet we economists have written countless studies about the stock market. Here is a summary of what we know:THE MARKET PROCESSES INFORMATION QUICKLY One prominent theory of the stock market — the efficient markets hypothesis — explains how answering my mother’s question would be a fool’s errand. If I knew anything good about a company, that news would be incorporated into the stock’s price before I had the chance to act on it. Unless you have extraordinary insight or inside information, you should presume that no stock is a better buy than any other.This theory gained public attention in 1973 with the publication of “A Random Walk Down Wall Street,” by Burton G. Malkiel, the Princeton economist. He suggested that so-called expert money managers weren’t worth their cost and recommended that investors buy low-cost index funds. Most economists I know follow this advice.PRICE MOVES ARE OFTEN INEXPLICABLE Even if changes in stock prices are unpredictable, as efficient markets theory suggests, we should be able to explain these changes after the fact. That is, we should be able to identify the news that causes stock prices to rise and fall. Sometimes we can, but often we can’t....MORE
HT: Abnormal Returns
A week ago I mentioned the incredible swings of October 2008: Down 20% in a week, up 11 and 10 percent in a day etc.
My favorite observation on the Efficient Market Hypothesis came from a commenter at Marginal Revolution and was worthy of a post:
Tuesday, October 28, 2008Climateer Line of the Day: 11% Up Division
From Commenter Paul on Marginal Revolution's post
I believe in the semi-strong efficient markets hypothesis. That is, around 2pm EDT today, something happened to make the fair value of equities 8% higher.