What led Fama to develop Efficient markets hypothesis? (comments on behavioral finance etc..as well).

A super interview of Eugene F. Fama by Robert Litterman.

What was his switch moment which led to development of his core ideas? Well, it was his work experience as a stock market analyst:

Litterman: In developing these ideas, was there  a particular point at which “the light went on,” so  to speak? 
Fama: Yes. When I was an undergraduate, I worked for a stock market forecasting service.  My job was to devise mechanical trading rules  that worked. But the rules I devised worked only  on past returns; they never worked when applied going forward or out of sample. After two years of   graduate school, I started talking to Merton Miller,  Lester Telser, and Benoît Mandelbrot—a frequent  visitor at the University of Chicago. They were  thrashing around the idea of what prices would look like if markets worked properly. That was my path into research on market efficiency and equilibrium risk–return models.

As the market efficiency ideas took shape, it  dawned on me that the reason the trading rules I’d  developed earlier didn’t work out of sample was  because price changes were random, which at that  point was what people thought an efficient market meant. We know now it doesn’t. Market efficiency  means that deviations from equilibrium expected  returns are unpredictable based on currently available information. But equilibrium expected returns  can vary through time in a predictable way, which means price changes need not be entirely random.

Interesting. Some kind of real world exp always helps…

On beh finance:

Litterman: In the past, you’ve said that behavioral finance is ex post storytelling and doesn’t generate new testable hypotheses. With the development of this literature, has your view changed  about that?

Fama: I think the behavioral finance literature is  very good at the micro level—individual behavior.  But the jumps that are made from the micro level  to the macro level—from the individual to markets—aren’t validated in the data. For example, the behavioral view is that a value premium exists and  it’s irrational. If it’s irrational, it should go away,  but it doesn’t seem to have gone away. Behavioral  finance also claims to explain momentum and  reversal. That’s too flexible in my view. It’s not a  science. In Daniel Kahneman’s book Thinking, Fast  and Slow, he states that our brains have two sides:  One is rational, and one is impulsive and irrational.  What behavior can’t be explained by that model?

Not really sure about this. If premium is irrational, why should it go away? It is irrational and hence it exists. It is rational school which thinks if something is irrational it should not be there…On that count humans themselves should not exist as they are anything but irrational…The primary finding or premise of behavioral finance/economics is that people/markets are irrational and this could persist forever..

He thinks Volcker rule will not help. I-banks will continue their business as usual. A better way is to raise capital for banks. Also speaks on US federal budget issue and looming pensions crisis..


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