Joe Walker interviews Eugene Fama (Nobel ’13) with the title “For Whom is the Market Efficient?” (The Joe Walker podcast, December 31, 2024). Here are some bits and pieces of their exchange that caught my eye.
Are financial markets efficient?
WALKER: Gene, I was talking with a few friends who work in high finance in preparation for this conversation. And one of my impressions is that a lot of people think of you as holding this extreme position that markets are perfectly rational. But I know that you don’t believe that, and I’ve also heard people who’ve taken your classes at Chicago say that you repeat ad nauseam that models aren’t real and the question is really: how efficient are markets?
FAMA: There’s a different way of putting it, actually: who is it efficient for? That’s another way to put it.
WALKER: Can you elaborate on that?
FAMA: Well, for almost everybody, the market is efficient in the sense that they don’t have information that’s not already built into prices. People who have special information, the market’s not efficient for them. So let’s say insiders, for example, typically have special information. So as far as they’re concerned, this stock is not priced totally efficiently because they have information they know will change the price. But for everybody else, assuming it’s efficient, it may be a really good approximation. … So if you say, tell me about professional investors, I’ll say a very small fraction of them show evidence of having information that isn’t already built into the price. So that’s going to the top of the food chain, saying even among the professionals, there are very few that have information that isn’t already in the price. If I go out to the public, alright, the market’s efficient for everybody out there.
Why all tests of market efficiency involve a “joint hypothesis,” because they are tests of the underlying model of price formation in financial markets.
So the problem is, this is what I call the joint hypothesis problem. You can’t tell me that prices reflect all available information unless you take a stance on what the price should be. So you have to have some model that tells me, for example, what is risk and what’s the relation between risk and expected return. And then we can look at deviations from that and see if the market is efficient. So there is what I call this joint hypothesis problem. You need a model that tells you how prices get formed. So in the jargon that’s called a model of market equilibrium. You need to join that with efficiency, then I can test it in the context of whatever model you tell me is determining prices. …
Okay, so you cannot test market efficiency without a story about risk and return, which is a market equilibrium issue. The reverse is also true. You can’t test models of market equilibrium without market efficiency. So these two things are like joined at the hip. They can’t be separated. People who do market efficiency, they almost don’t exist anymore. Everybody takes it for granted in the academic sphere. It’s considered uninteresting to test. But everybody that does market efficiency understands the joint hypothesis problem. But it’s not that widely recognized among the people who do asset risk and return models. It’s implicitly assumed, but they never make it explicit.
Why Fama, and others who argue for market efficiency, are the most important figures in behavioral economics.
FAMA: Behavioral finance, well, that had its time, but everything is behavioral after all. … Now the problem is that behavioral finance, behavioral economics, doesn’t have any models of their own. It’s just a criticism of other models. So I’ve always chided Dick Thaler and told him, “Hey, it’s easy to criticize my models if that’s what you guys do. Give me a model of yours that I can criticize.” Never happens. I really get under his skin when I say, well, there’s no real behavioral economics. It’s just a branch of efficient markets. You don’t have a model of your own. You just have a criticism of efficient markets. So they’re really just my cousin.
WALKER: I heard a debate between you and Thaler where you said that you were the most important person in behavioral finance.
FAMA: That’s what I said. That’s another one of my lines. Without efficient markets they’d have nothing to criticize.
