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Journal of Economic Perspectives-Volume 17, Number 1 - Winter 2003 - Pages 83 - 104
(ProQuest Information and Learning: ... denotes Formulae omitted.)
Academic finance has evolved a long way from the days when the efficient markets theory was widely considered to be proved beyond doubt. Behavioral finance-that is, finance from a broader social science perspective including psychology and sociology-is now one of the most vital research programs, and it stands in sharp contradiction to much of efficient markets theory.
The efficient markets theory reached its height of dominance in academic circles around the 1970s. At that time, the rational expectations revolution in economic theory was in its first blush of enthusiasm, a fresh new idea that occupied the center of attention. The idea that speculative asset prices such as stock prices always incorporate the best information about fundamental values and that prices change only because of good, sensible information meshed very well with theoretical trends of the time. Prominent finance models of the 1970s related speculative asset prices to economic fundamentals, using rational expectations to tie together finance and the entire economy in one elegant theory. For example, Robert Merton published "An Intertemporal Capital Asset Pricing Model" in 1973, which showed how to generalize the capital asset pricing model to a comprehensive intertemporal general equilibrium model. Robert Lucas published "Asset Prices in an Exchange Economy" in 1978, which showed that in a rational expectations general equilibrium, rational asset prices may have a forecastable element that is related to the forecastability of consumption. Douglas Breeden published his theory of "consumption betas" in 1979, where a stock's beta (which measures the sensitivity of its return compared to some index) was determined by the correlation of the stock's return with per capita consumption. These were exciting theoretical advances at the time. In 1973, the first edition of Burton Malkiel's acclaimed book, A Random Walk Down Wall Street, appeared, which conveyed this excitement to a wider audience.
In the decade of the 1970s, I was a graduate student writing a Ph.D. dissertation on rational expectations models and an assistant and associate professor, and I was mostly caught up in the excitement of the time. One could easily wish that these models were true descriptions of the world...