If the efficient markets theory needs to be abandoned, the effect on investing will be profound. More important still is what will come to replace it
Don Putnam, designer of investment products since the 1970s, points to the most fundamental of lessons learnt from last year’s global financial implosion: markets are “defined by their participants as much as they are by their mechanics” and it is people’s motivations that ultimately count.
“The car is important but the driver is crucial – and a panic among the drivers, if you will, makes the technologies of roadways irrelevant,” says Mr Putnam, who runs Grail Partners, a boutique Boston investment bank.
To some, that conclusion may seem self-evident. But to accept it sweeps away assumptions that for half a century formed the foundations of the financial industry. The reigning theory, often referred to in shorthand as “efficient markets”, is deeply embedded in the way that markets operate. The regulations for pension funds and banks both ultimately hinge on these assumptions. So does much law on securities fraud.
It is central to business schools’ curriculum and is part of the Chartered Financial Analyst qualification that acts as a gateway to the investment profession. Fund managers run their businesses by comparing their performance against benchmark indices, another idea from efficient markets. The products based on derivatives that grew notorious for their role in the market crash all stemmed directly from efficient markets theory.
If the theory needs to be abandoned, the effect on investing will be profound. More important still is what will come to replace it. Efficient markets borrowed from mathematics but that is now widely regarded as an oversimplified and often downright misleading theory that fostered the cavalier confidence leading to the crash.
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