Pablo Triana: Efficient Market Theory is not to Blame

Sunday’s Financial Times has an interesting piece written by Pablo Triana, who argues against the notion of  the ‘efficient-market hypothesis’ (‘EMH’ suggests that the stock market can’t be beaten on any consistent basis because all available information is already built into PPS) being directly responsible for the financial mess we currently find ourselves in. Mr. Triana points out how the crisis has in fact helped restore the once-orthodoxy financial theory, and emphasizes that had Wall Street abided by the theory, they would have tried to make money by ” boringly replicating the index funds, not by selling optionality through CDS.”

EMH has been attacked lately both empirically and theoretically by critics who blame belief in rational markets for much of the current financial crisis.

Here are a few excerpts from Triana’s article :

From the FT: Espousers of the “efficient market theory did it” camp seem to argue that, by providing unmitigated faith in the soundness of quoted market prices, the notion that everything is behaving rationally, and that no dangerous bubbles can take shape, the analytical machination made investors and policymakers complacent and careless, allowing the (very real, very irrational) housing-related blow-up to happen.

This line of reasoning suffers from an obvious drawback: can we really assume that all professionals are basing their actions all the time on the dictates of the efficient market hypothesis? That they are even aware of the existence of such theory?

Of course not. I mean, it’s not as if the Merrill Lynch traders who gorged on subprime credit default obligations did so because they religiously abided by Prof Fama’s (earlier, at least) pontifications. Or that regulators allowed the insane leverage to take place because their brains repeatedly flashed out the “markets are efficient, markets are efficient!” signal.

Efficient market theory is an ideology a few may share, but it is not a mechanism for direct action-taking. As such, and unlike the theories that truly caused the crisis, it cannot lead to activities by professionals that may cause trouble.

There is also the point that the efficient market hypothesis says markets cannot be beaten, and yet the current nightmare was created by those who very much wanted to outperform.

Had Wall Street and the City abided by the theory, they would have gorged on index funds rather than on subprime CDOs. They would have tried to make money by boringly replicating the index, not by selling optionality though credit default swaps.

Rather than being followed, the efficient market theory was scorned.

emphasis added

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