Content area
Full Text
For those who look to the Nobel Prize committee for guidance on market efficiency, the decision to award the 2013 Nobel Prize in economics to both Eugene Fama and Robert Shiller might be puzzling. "If you've been wondering whether it's possible to regularly beat the stock market averages," wrote Steven Rattner [2013], a Wall Street financier and commentator, "you didn't get any guidance from the Nobel Prize committee this year." Rattner placed Shiller in one corner, claiming that he "argues that markets are often irrational and therefore beatable." He placed Fama in the opposite corner, describing him as "the father of the view that markets are efficient," whose "followers believe that investors who try to beat the averages will inevitably fail."
The efficient market hypothesis is central to standard finance, and many believe that behavioral finance refutes it. Indeed, many believe that refutation of the efficient market hypothesis is the most important contribution of behavioral finance. Yet, as Statman [2017] pointed out in Finance for Normal People, discussions are unfocused when they fail to distinguish between two versions of efficient markets and their corresponding efficient market hypotheses, the price-equals-value market hypothesis and the hard-to-beat market hypothesis. Discussions are lacking when they fail to explain why so many investors believe that markets are easy to beat.
Evidence gathered in both standard and behavioral finance contradicts the price-equals-value market hypothesis but it is consistent with the hard-to-beat market hypothesis. Behavioral finance also answers a question standard finance usually fails to ask: Why do so many investors believe that markets are easy to beat when, in truth, they are hard to beat? The answer combines investors' wants and their cognitive and emotional errors.
Price-equals-value markets are markets in which investment prices always equal their intrinsic values, and the price-equals-value market hypothesis is the claim that investment prices always equal their intrinsic values. Hard-to-beat markets are markets in which some investors are able to beat the market, earning consistent excess returns, but most are unable to do so. Excess returns generally correspond to above-average returns. More precisely, they are returns in excess of returns that can be expected according to a correct asset pricing model.
Price-equals-value markets are impossible to beat because excess returns come from exploiting gaps between...