As economists say at the University of Chicago, free markets work efficiently, except maybe when it came to predicting the 2007 winner of the Nobel Prize for economics.
Last week, Internet-based prediction market Entrade Inc., through which people “bet” on all sorts of events, correctly forecast Al Gore would win the Nobel Peace Prize.
But Entrade’s list of likely winners of the $1.5 million Nobel Memorial Prize in Economic Sciences, awarded Monday, did not mention any of the three winners, including U. of C. economics professor Roger Myerson. As of Friday, the top contender was another Chicago Maroon, Eugene Fama of the university’s graduate school of business.
Fama, 68, considered the father of efficient market theory, has been a bridesmaid but not a bride in the annual Nobel economics competition for many years. “I’m not losing any sleep over it,” he said Monday. Recently, he won $200,000 as the first recipient of the Morgan Stanley-American Finance Association Award for excellence in finance.
Fama said he was unfamiliar with Myerson’s work, but said the committee that awards the prize seems to have a preference for mathematically based economic theories, as opposed to empirical research based on what actually happens in economic settings, such as the stock market.
“Among mathematical economists, they probably don’t even think efficient markets is much of a theory,” he said.
But investors searching for practical clues for building a portfolio can learn much from both points of view. Understanding the work of both economists is especially useful for anyone serious about international investing.
As a student, Fama became intrigued with the power of freely traded securities markets when he took a course from a professor who claimed to have a system to beat the stock market. Viewed in hindsight, the professor’s system always worked. But it failed to predict future stock prices.
Fama developed the idea that the stock market constantly processes new information, based on the knowledge and risk appetite of buyers and sellers.
Even such human foibles as overoptimism and underoptimism toward investment opportunities work themselves out within the architecture of free securities markets, he says.
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The price transacted in the market contains the available information and sentiment. But because no one can know all that the market knows, Fama’s theory suggests, nearly all investors are better off owning low-cost index funds that passively own a broadly diversified basket of stocks.
Myerson and his Nobel associates endorse the power of markets, as well. But their definition of markets is more expansive. Would-be buyers and sellers in the stock market or competitors in a negotiation within an organization come to the interchange with many incentives and motives, as well as knowledge.
Even a socialist economy can produce efficiency under certain circumstances, he said. Likewise, the notion of efficient markets in a capitalist system requires “certain assumptions,” Myerson told a press conference at the university’s Hyde Park campus Monday.
For example, efficient market theory says the price determined by buyers and sellers concluding transactions contains all of the available information about a stock.
But Myerson said there can be “efficiencies in a failure to trade,” as when people in a bargaining situation walk away from the table. There is no transaction at that point, but bargainers might learn to communicate better.
Oddly, one real-world example Myerson offers of his approach concerns the U.S. invasion of Iraq. In a recent paper, Myerson critiqued “My Year in Iraq,” the 2006 book by Paul Bremer, who had been head of U.S. operations in Iraq, and the Army’s “Counterinsurgency Field Manual.”
In brief, Myerson faulted the U.S. insistence on obtaining a written constitution as a primary goal for Iraq. Like stock market regulations, a national constitution is only as good as the people who enforce it. Bremer’s first task should have been recruiting and rewarding local leaders willing to form effective political networks, Myerson said.
“It may be misleading to think of the constitution as the essential cornerstone of a democratic government,” he wrote.
Likewise, investors in emerging economies frequently are warned that the legal architecture of many nations is a far cry from the freedoms and safeguards investors in the U.S. stock market enjoy.
Using Myerson’s theory, the rewards for investors might be enough to overcome their prejudices based on U.S.-style market capitalism.
Nonetheless, most investors would be well advised to limit their exposure to emerging markets and to diversify their international bets widely, just as Fama’s efficient market theory indicates.
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