Arnold Kling  

Fama vs. Thaler

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Stephen Bainbridge judges the contest.


As for regulators, because the ECMH [Efficient Capital Markets Hypothesis] is often brought to bear as a justification for deregulation in politically charged policy disputes, such as mandatory corporate disclosure and insider trading, those who support regulation of such areas find comfort in the behavioral critique. One problem with such arguments, of course, is that it takes a theory to beat a theory, and no behavioralist theory yet advanced does a better job of explaining the vast bulk of stock market phenomena than the ECMH.

See also this blog entry by Larry Ribstein.


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.

For Discussion. Can imperfect government regulators protect imperfect investors from themselves?



TRACKBACKS (1 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/148
The author at Different Opinion in a related article titled Regulate Perfect Markets? - ! writes:
    markets are efficient in part because they are regulated: ... So it's not that straightforward to claim a link between market efficiency and deregulation. ... Can't even the most imperfect government protect investors from overstating their creditworth... [Tracked on October 20, 2004 5:21 PM]
COMMENTS (11 to date)
A. West writes:

Even if markets are not perfectly efficient, which they aren't, that doesn't mean that they must be regulated. Government may just make an imperfect market even more inefficient. Thaler, in the recent WSJ article came out looking like a real tyrant in the making.

Also, ethically, why shouldn't dumb investors suffer the consequences of their mistakes?

Robert Schwartz writes:

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.

Lawrance George Lux writes:

All investors are imperfect, it is only the degree of imperfection; otherwise, We are talking of Insider-trading here. Could a market exist without imperfect Traders--I mean, would Anyone be willing to either Buy or Sell, except at the perfect equilibrium price? There would be a perfectly static market, with all assets settling into permanent possession.

Imperfect Government regulators, on the other hand, can vastly improve market performance by insisting on more astute 'fleecing of the Suckers'. This insists both Buyers and Sellers become more knowledgeable about market conditions. lgl

nelziq writes:
Posted by Lawrance George Lux on October 21, 2004 11:15 AM Imperfect Government regulators, on the other hand, can vastly improve market performance by insisting on more astute 'fleecing of the Suckers'. This insists both Buyers and Sellers become more knowledgeable about market conditions.

There is a lot of money to be made by being knowledgable about investment market conditions. Unfortunately, there is very high price for obtaining the relevant information (otherwise it would be easy to make money in the equity markets). It pays for a vast majority of investors to be rationally ignorant about their individual investments. They employ fund managers to choose specific equities and magazines or other third-party rating systems to choose thier fund managers. It is no more useful to use the government to force people to acquire a certain amount of information than it is to force a person to buy a certain number of shoes.

Bernard Yomtov writes:

And what are Bainbridge's qualifications for judging this contest?

What predictive power does the "behavioral" school's models have? How falsifiable are their assertions? While the EMH crowd doth tend to overstate things, by and large their predictions hold up.

Bob writes:

Behavioral theories have no meaningful predictive power at this point. To date, this line of thought is useful only because it raises interesting questions. Even the attempt to produce models with testable implications are in their infancy. Those who are interested in why Thaler's work is just stories with no solid intellectual foundation should read John Cochrane's "Stocks as Money" paper available at http://gsbwww.uchicago.edu/fac/john.cochrane/research/Papers/cochrane_stock_as_money.pdf

No matter which story you choose to believe, it is important to recognize them for what they are. That said, I think behavioral research is useful, if not yet highly relevant. We tend to forget that there is no way to directly test the efficient market hypothesis either. People will figure out what are anecdotes and what is real.

To build on nelzig and lgl's comments, both are right to a certain extent. It is silly and wasteful to force all individuals to gather and process information on investment values. But the more people who do, the better the markets function. Free-riding by most investors is double edged sword. In theory, the gov certainly could improve the outcome. In practice, I doubt it. I like how Arnold framed the question. To answer it you have to ask are the regulators smarter than the investors and do they have better incentives?

A. West writes:

I don't think it's accurate to say behavioral theories have no predicative power. There are analyst overconfidence and underreaction studies that seem to show predicative power. Also, there are several papers by Lakonishok, Vishny, and Schleifer on value stocks. They see pretty much the same factor that Fama-French do, but interpret superior returns to value stocks as a behavioral issue providing exceptional returns, while Fama-French say they think it is a premium offered in return for a risk that cannot be exactly identified.

Bob writes:

No. The existing studies are stories designed explicitly to explain widely-known empirical facts. A theory with predictive power generates an empirical implication that is unknown and is subsequently shown to be true. Hong and Stein (Journal of Finance, Dec 99) is a step in this direction.

Tom writes:

Markets tend to be self correcting and, when left alone, they weed out the incompetent. Government bureaucrats, on the other hand, tend to perpetuate their mistakes for as long as Congress allows -- which seems to be forever.

cb writes:

Earlier post

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.


I'm not sure if you just have a bad attitude about brokers or you had a bad experience, but whether you like it or not, all securities are sold via commissioned brokers, equity and fixed. If you don't like your broker, go with a fee-based advisor, who will be buying from commission-based brokers, discount shop or not.

Your comment regarding 'the small guy' not having time to read and do research, etc. is the point of having a broker, or using packaged products.

There is no problem in our capital markets regarding the amount of information, we all have access to it (I send 75 page transcripts of conference calls w/ management to clients all the time). The issue is spending the time to find it and process it (which includes being able to understand what is relevant information, and what isn't).

Having both institutional and retail clients, there have been many instances where some hedge fund wants to sell a block of bonds and some retail account wants to buy them, with the 'unsophisticated and abused' retail account coming out for the best in the end. Looking at the performance of funds (mutual and hedge) I refuse to believe that 'sophisticated' money managers have any inherent advantage.

And besides, we're talking about supposed market distortions and whether we need more regulations to protect the little guy from their own stupidity. I posit that any supposed market distortion is caused by those that have the size to effect the distortion (pardon my grammar), which is not retail accounts. In a related comment, anybody that thinks the late 90's bubble was caused by a bunch of day-traders and other retail accounts is mistaken. Those people are specks of dust compared to the institutional involvement.

Besides, who do you think lost the most money in the Enron/WorldCom/etc. - yes, that's right, the 'sophisticated' big boys.

My point is not to defend brokers (many of my RIA client's assets came from commission brokerage accounts), but to say there is no need for commissioned brokers shows a lack of understanding of the securities market. And besides, I can't go to the bathroom w/o permission from my compliance dept., I don't see how a bunch of regulators passing more regulations is going to do anything. Like I said, if you don't like your broker, get another one, or go to a fee-based guy. In my opinion, all the stupid regulations we do have, which you're complaining about, 'bad joke' as you called them, are a result of people like you, who bitch and say what you think needs to be done, but don't even understand the markets anyway.

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