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Paul Samuelson
Paul Anthony Samuelson (May 15, 1915 – Dec. 13, 2009) was the first American to win the Nobel Prize in Economics (1970). The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in economic theory". He is often referred as the "Father of Modern Economics" and is the most influential economist of the later 20th century.
He contributed fundamentally to the mathematical foundations of economics with his book Foundations of Economic Analysis. He was author of the best-selling economics textbook of all time: Economics: An Introductory Analysis, first published in 1948. Samuelson had a regular column in Newsweek from 1966 to 1981. It was Samuelson who provided the first formal economic argument for "efficient markets" (1965). His contribution is neatly summarized by the title of his article: "Proof that properly anticipated prices fluctuate randomly". He explained how the theory of random walks in stock market prices presents important challenges to the proponents of both technical analysis and fundamental analysis. The efficient markets theory (EMT) of financial economics states that the price of an asset reflects all relevant information that is available about the intrinsic value of the asset. Although the EMT applies to all types of financial securities, discussions of the theory usually focus on one kind of security, namely, shares of common stock in a company. A financial security represents a claim on future cash flows, and thus the intrinsic value is the present value of the cash flows the owner of the security expects to receive. Theoretically, the profit opportunities represented by the existence of “undervalued” and “overvalued” stocks motivate investors to trade, and their trading moves the prices of stocks toward the present value of future cash flows. Thus, investment analysts’ search for mis-priced stocks and their subsequent trading make the market efficient and cause prices to reflect intrinsic values. Because new information is randomly favorable or unfavorable relative to expectations, changes in stock prices in an efficient market should be random, resulting in the well-known “random walk” in stock prices. Thus, investors cannot earn abnormally high risk-adjusted returns in an efficient market where prices reflect intrinsic value. While this evidence was generally viewed as supporting the random walk model of stock returns, there was no formal understanding of its economic meaning, and some mistakenly took this randomness as an indication that stock returns were unrelated to fundamentals, and thus had no economic meaning or content. Samuelson's work explained that such randomness in returns should be expected from a well-functioning stock market. Their key insight was that competition implies that investing in stocks is a “fair game,” meaning that a trader cannot expect to beat the market without some informational advantage. The essence of the “fair game” is that today’s stock price reflects the expectations of investors given all the available information. Therefore, tomorrow’s price should change only if investors’ expectations of future events change, and such changes should be randomly positive or negative as long as investors’ expectations are unbiased. This revelation had its roots in the developing rational expectations theory of macroeconomics, and thus, some economists refer to the EMT as the “rational markets theory.” It was later recognized that the “fair game” model allows for the expectation of a positive price change, which is necessary to compensate risk-averse investors. More than any other economist, Paul Samuelson raised the level of mathematical analysis in the profession. Until the late 1930s, when Samuelson started his stunning and steady stream of articles, economics was typically understood in terms of verbal explanations and diagrammatic models. Samuelson wrote his first published article, “A Note on the Measurement of Utility,” as a twenty-one-year-old doctoral student at Harvard. He introduced the concept of “revealed preference” in a 1938 article. Revealed preference theory tries to understand the preferences of a consumer among bundles of goods, given their budget constraint. For instance, if the consumer buys bundle of goods A over bundle of goods B, where both bundles of goods are affordable, it is revealed that he/she directly prefers A over B. It is assumed that the consumer's preferences are stable over the observed time period, i.e. the consumer will not reverse their relative preferences regarding A and B. | ||
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Eugene Fama
Eugene F. Fama (Feb. 1, 1939 - ) is known as the father of empirical finance. Over an unusually active career that spans more than five decades, Fama has produced pioneering research on efficient capital markets, asset pricing models, as well as the behavior of interest rates, exchange rates, futures prices, and inflation rates. He has also produced important papers on capital structure and payout policy. His theoretical work on agency problems and banking is path breaking and influential.
Fama essentially invented the concept of efficient capital markets in his early work on the time series behavior of stock prices. He extended it, in collaboration with Larry Fisher, Mike Jensen and Dick Roll, in a study of stock splits that pioneered the technique of “event studies.” They found that once information about the existence of a stock split becomes known to the public, there are no abnormal returns available by either buying or selling a stock that is splitting. Event studies have been used in many fields of applied economics and have become an integral part of securities law through the concept of “reliance” and “fraud on the market.” At the same time that Fama was formulating the idea of the efficient markets hypothesis, Sharpe (1964), Lintner (1965), and Mossin (1966) were developing the capital asset pricing model (CAPM) base d on Markowitz’ (1952, 1959) model for portfolio selection. Fama (1968) clarified this model and showed that the apparent differences between the Sharpe and Lintner models were not real. In 1970, Eugene Fama published his now-famous paper, “Efficient Capital Markets: A Review of Theory and Empirical Work.” Fama synthesized the existing work and contributed to the focus and direction of future research by defining three different forms of market efficiency: weak form, semi-strong form, and strong form. In a weak-form efficient market, future returns cannot be predicted from past returns or any other market-based indicator, such as trading volume or the ratio of puts (options to sell stocks) to calls (options to buy stocks). In a semi-strong efficient market, prices reflect all publicly available information about economic fundamentals, including the public market data (in weak form), as well as the content of financial reports, economic forecasts, company announcements, and so on. The distinction between the weak and semi-strong forms is that it is virtually cost-less to observe public market data, whereas a high level of fundamental analysis is required if prices are to fully reflect all publicly available information, such as public accounting data, public information regarding competition, and industry-specific knowledge. In strong form, the highest level of market efficiency, prices reflect all public and private information. This extreme form serves mainly as a limiting case because it would require even the private information of corporate officers about their own firm to be already captured in stock prices. A simple way to distinguish among the three forms of market efficiency is to recognize that weak form precludes only technical analysis from being profitable, while semi-strong form precludes the profitability of both technical and fundamental analysis, and strong form implies that even those with privileged information cannot expect to earn excess returns. Their main point is that market frictions, including the costs of security analysis and trading, limit market efficiency. Thus, we should expect to see the level of efficiency differ across markets, depending on the costs of analysis and trading. Although weak-form efficiency allows for profitable fundamental analysis, it is not difficult to imagine a market that is less than weak form but still relatively efficient in some sense. Thus, it can be useful to define the efficiency of a market in a more general, continuous sense, with faster price reaction equating to greater informational efficiency. While most of the empirical research of the 1970s supported semi-strong market efficiency, a number of apparent inconsistencies arose by the late 1970s and early 1980s. These so-called anomalies include, among others, the “small-firm effect” and the “January effect,” which together document the tendency of small-capitalization stocks to earn excessive returns, especially in January. But financial economists today attribute most of the anomalies to either mis-specification of the asset-pricing model or market frictions. For example, the small-firm and January effects are now commonly perceived as premiums necessary to compensate investors in small stocks, which tend to be illiquid, especially at the turn of the year. Fama (1998) also notes that the anomalies sometimes involved under-reaction and sometimes over-reaction and, thus, could be viewed as random occurrences that often went away when different time periods or methodologies were used. | ||
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Robert Shiller
Robert James "Bob" Shiller (March 29, 1946 - ) is an American Nobel Laureate, economist, academic, and best-selling author. He currently serves as a Sterling Professor of Economics at Yale University. Shiller has been a research associate of the National Bureau of Economic Research (NBER) since 1980.
His book Irrational Exuberance (2000) – a New York Times bestseller – warned that the stock market had become a bubble in March 2000 (the very height of the market top) which could lead to a sharp decline. Shiller in 2005 described the rapid rise of housing prices as a bubble and warned that prices could fall by 40 percent. Five years later, with home prices well on the way to fulfilling Mr. Shiller’s prediction, the economist Eugene Fama said he still did not believe there had been a bubble. “I don’t even know what a bubble means,” said Fama, the author of the theory that asset prices perfectly reflect all available information. “These words have become popular. I don’t think they have any meaning.” The two men, leading proponents of opposing views about the rationality of financial markets — a dispute with important implications for investment strategy, financial regulation and economic policy — were joined in unlikely union as winners of 2013 Nobel Prize in Economics. Fama’s seminal theory of rational, efficient markets inspired the rise of index funds and contributed to the decline of financial regulation. Shiller, perhaps his most influential critic, carefully assembled evidence of irrational, inefficient behavior and gained a measure of fame by predicting the fall of stock prices in 2000 as well as the housing crash that began in 2006. The dispute is not merely academic. The deregulation of financial markets beginning in the 1980s was justified by the view that markets are rational and efficient. Complacence about rising home prices in the 2000s similarly reflected the view that prices are inherently rational. In the aftermath of the crisis, conversely, the work of Shiller and other proponents of behavioral economics — the integration of psychology into economic models — has been influential in shaping an intensification of financial regulation. And Federal Reserve officials are now debating whether bubbles can be identified and when they should be popped. The Efficient Market Theory has been repeatedly validated, sometimes in experiments involving actual monkeys. And while many market prognosticators on Wall Street still thrive in part by claiming that they can offer investments that will consistently beat the market averages, Fama’s well established theory has influenced the way millions of people now invest, contributing to the popularity of index funds that hold broad, diversified baskets of equities. Shiller introduced in the early 1980s an important limitation on the idea that markets operate efficiently. He showed that the volatility of stock prices was greater than the volatility in corporate dividends. Moreover, he found that some of those irrational deviations fell into predictable patterns. Fama is among the economists who have since documented other patterns of predictable price movements, although he explains these patterns as a form of compensation for the greater risk associated with some assets. Shiller, by contrast, has argued that the predictability of prices reflects irrational but repeating patterns in human behavior, and he is among a group of prominent economists who are trying to integrate behavioral theories from psychology and other social sciences into rigorous models of economic activity. Shiller wrote in “Market Volatility,” a 1989 book published by MIT Press, that the assertion stock prices were rational was “one of the most remarkable errors in the history of economic thought.” Instead, he wrote, “Mass psychology may well be the dominant cause of movements in the price of the aggregate stock market.” Bubbles are one of the most tangible manifestations of the disagreement between Shiller and Fama. The housing crash that began in 2006 is widely regarded as evidence that prices had climbed to irrational heights, and Shiller’s accuracy in diagnosing the problem suggests that future bubbles could be identified, too. But Fama, like other proponents of efficient markets theory, is dismissive of Shiller’s record as a forecaster and more broadly, of claims that it is possible to consistently identify asset bubbles before a collapse. Asked in 2010 about those who warned that housing prices would crash, he responded, “Right. For example, Shiller was saying that since 1996.” In 1981 Shiller published an article in The American Economic Review titled "Do stock prices move too much to be justified by subsequent changes in dividends?" in which he challenged the efficient-market hypothesis, which was the dominant view in the economics profession at the time. Shiller argued that in a rational stock market, investors would base stock prices on the expected receipt of future dividends, discounted to a present value. He examined the performance of the U.S. stock market since the 1920s, and considered the kinds of expectations of future dividends and discount rates that could justify the wide range of variation experienced in the stock market. Shiller concluded that the volatility of the stock market was greater than could plausibly be explained by any rational view of the future. The behavioral finance school gained new credibility following the October 1987 stock market crash. Shiller's work included survey research that asked investors and stock traders what motivated them to make trades; the results further bolstered his hypothesis that these decisions are often driven by emotion instead of rational calculation. Much of this survey data has been gathered continuously since 1989. Stock Market Confidence Indices is an on-going Investor Behavior Project at Yale University. It is under the direction of Robert Shiller since its beginning and now under the auspices of the Yale International Center for Finance, has been collecting questionnaire survey data on the behavior of US investors since 1984. Among the studies that this project has produced was a major study of investor thinking on the day of the stock market crash of 1987. As part of this project, regular questionnaire investor attitude surveys have been done continuously since 1989. The following reports on some stock market confidence indexes derived from this survey data. These indexes have a span of nearly twelve years, and thus are the longest-running effort to measure investor confidence and related investor attitudes. While prices may take long, slow swings away from fundamentals, the EMT is still useful in at least two important ways. First, over shorter horizons, such as days, weeks, or months, there is considerable evidence that the EMT can explain the direction of stock price changes. That is, the response of stock prices to new information reasonably approximates the change in the intrinsic value of equity. Second, the EMT serves as a benchmark for how prices should behave if capital investments and other resources are to be allocated efficiently. Just how close markets come to this benchmark depends on the transparency of information, the effectiveness of regulation, and the likelihood that rational arbitragers will drive out noise traders. | ||
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Andrew Lo
Andrew Wen-Chuan Lo (April 18, 1960 - ) is Professor of Finance at the MIT Sloan School of Management. Lo is the author of several academic articles in Behavioral Finance and Financial economics. He is closely followed by the most sophisticated hedge funds. Lo's Adaptive Markets Hypothesis attempts to combine the rational principles of the efficient market theory with the irrational principles of behavioral finance.
With more serious challenges to the EMT emerged from research on long-term returns, the apparent market inefficiencies contributed to the emergence of a new school of thought called behavioral finance, which countered the assumption of rational expectations with evidence from the field of psychology that people tend to make systematic cognitive errors when forming expectations. One such error that might explain overreaction in stock prices is the representative heuristic, which holds that individuals attempt to identify trends even where there are none and that this can lead to the mistaken belief that future patterns will resemble those of the recent past. On the other hand, momentum in stock returns may be explained by anchoring, the tendency to overweight initial beliefs and underweight the relevance of new information. It follows that momentum observed over intermediate horizons could be extrapolated over longer time horizons until overreaction develops. This does not, however, imply any easily exploitable trading strategy, because the point where momentum stops and overreaction starts will never be obvious until after the fact. The adaptive market hypothesis, as proposed by Andrew Lo, is an attempt to reconcile economic theories based on the efficient market theory (which implies that markets are efficient) with behavioral economics, by applying the principles of evolution to financial interactions: competition, adaptation and natural selection. Under this approach, the traditional models of modern financial economics can coexist with behavioral models. Lo argues that much of what behaviorists cite as counterexamples to economic rationality—loss aversion, overconfidence, overreaction, and other behavioral biases—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment using simple heuristics. According to Lo, the adaptive market hypothesis can be viewed as a new version of the efficient market hypothesis, derived from evolutionary principles: Prices reflect as much information as dictated by the combination of environmental conditions and the number and nature of "species" in the economy. By species, he means distinct groups of market participants, each behaving in a common manner, including pension fund managers, retail investors, market makers, hedge fund managers, etc. If multiple members of a single group are competing for rather scarce resources within a single market, then that market is likely to be highly efficient (for example, the market for 10-year U.S. Treasury notes). On the other hand, if a small number of species are competing for rather abundant resources, then that market will be less efficient. Market efficiency cannot be evaluated in a vacuum, but is highly context-dependent and dynamic. Shortly stated, the degree of market efficiency is related to environmental factors characterizing market ecology, such as the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants. The adaptive market hypothesis has several implications that differentiate it from the efficient market hypothesis:
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