GMAN 322: Are Markets Efficient?

Two videos on the Financial Times website show interviews with Burton Malkiel, and Benoit Mandelbrot (a famous mathematician). Both take slightly different views on efficient markets. Here are links to the two videos*:

  1. Malkiel
  2. Mandelbrot

The two may not seem connected, but they are more so than you might think. In the comments section below, write 20-40 words on what you think of efficient markets, based on the two interviews.

*The FT does not allow embedding of its videos on external sites so, unfortunately, you have to go there and watch it. Links will open in external windows/tabs.

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12 comments for “GMAN 322: Are Markets Efficient?

  1. Goran Kalas
    April 30, 2010 at 4:21 pm

    The EMH claims that one cannot consistently achieve returns in excess of average market returns. This is why Malkiel argues that investors are best off by investing in passive index funds instead of actively trading stocks. I believe to an extent that the EMH is correct but feel that investors who trade based on true principles can outperform the market. A perfect example is someone like Warren Buffet who made a fortune from investing into sound businesses with solid earnings and low PE ratios.

  2. Aaron Russo
    May 1, 2010 at 9:42 am

    I agree with Malkiel, that for the most part markets are efficient, and that most investors are infinitely better off with an index than with most money managers. My issue with his hypothesis is that he allows for so many exceptions. Like the Warren Buffetts or the George Soros of the world. Managers who continue to outperform the market over long periods of time. Their existence seems to illustrate inefficiency in the market that can be exploited. I think what Malkiel is really observing is a fundamental flaw in the market, which is that the number of managers is enormous, and since outperforming is not easy the numbers who underperform will of course be much larger. He also says in this video (and his book) that those who do outperform in one five year period, don’t do it in the next. Which is another observation that I feel is skewed by many outside factors. One factor that comes to my mind is motivation. Many managers come out of the gates hungry and trying to prove something, once they do and they make a lot of money it’s hard to put the same hours into the practice. Another factor I think combating any efficient market generalizations is the secrecy in the hedge fund markets. It’s not easy to find all this data; many funds don’t even publish it, so how can we say what they are doing on a consistent basis. So in closing I think that the market is efficient in a statistical sense, by which I mean that returns form a normal distribution around the market. There are managers that consistently outperform, just like there are those that consistently under perform. But those that outperform consistently prove that it’s a skill game. I would much rather put my entire 401k in Berkshire Hathaway, than in an S&P 500 fund. However I’m with Malkiel in the sense that I would also much rather put it in an S&P 500 fund than some random money manager…

  3. Han
    May 1, 2010 at 5:59 pm

    From the two interviews, I think market efficiency is random. Especially after the Goldman scandal, who would say that he or she still has 100% trust in the information available for securities trading, or that the current prices of securities reflect all information about the security? I may sound doubtful and pessimistic here but I believe luck plays a big role for investment success. Malkiel encourages investors to choose a broad based global index that is slightly overweight on China, while he mentions that the Chinese political system, the Chinese currency (exchange rate) and the information system are not fully established or stabled. Is that investment informationally efficient? Although higher risk yields higher return, why would Malkiel prefer a weak form of efficient market like China?

  4. Gordon Gray
    May 2, 2010 at 3:05 pm

    In essence, the efficient market theory in regard to prices in the market continues to be quite useful as a means to discourage investors from expecting long-term abnormal returns from money managers (or from their own adventures into stock/fund picking and market timing). You don’t even need the efficient market theory to understand that if someone has developed a method to gain abnormal returns, it will, eventually, be copied and it’s effectiveness diluted to nothing, or the market conditions favorable to the strategy will turn and obviate without warning the basis for the strategy working in the first place.

    However, as Mandelbrot asserts, to fully embrace and use the efficient market theory as a basis for balancing risks and returns in portfolio management, one must be willing to sweep outlier data under the rug. As it turns out (Engle, Bollerslev, etc.), returns are actually not normally distributed, but actually are both skewed and kurtotic, together indicating we all better watch out much more often than we’d like for “outlier” events (reference the ironically well timed book entitled The Black Swan, 2007, Taleb).

    In addition, with the still-nascent field of Behavioral Finance poking substantial holes in the assumptions of underlying rational investor behavior, there may be some arbitrage to be taken still. For example, fund returns from managers using known distortions in investor behavior don’t have a long enough track record but they may be interesting, at least until others copy or the market conditions turn.

    Clearly, modeling returns without assuming a normal distribution requires mathematical skills that surpass the average genius (what is a 10th moment of a mean, really?). But, it can be done, it is being done, and, I believe, that it must be done in order establish credible risk/return choices. (For an example, see

    All that said, Animal Spirits will always out-pull the assumption of rationality, and modeling social psychology with finesse will require an Asimovian-breakthroughs (as found in the Sci-Fi classic, Foundation Series).

  5. May 2, 2010 at 4:13 pm

    GMAN 322 students: Aaron and Gordon have already taken the equivalent of your class in the MS-FAIM program, so don’t be intimidated by their (very insightful) comments. I’m letting their comments through so you can read and learn from them.

  6. Keanee Chu
    May 2, 2010 at 9:33 pm

    Malkiel believes that owning a passively managed index fund will be better than an actively managed fund because of higher trading costs and expense ratios. Investors should diversify with a global index bearing a heavier weight towards China, especially since it’s an emerging market with the likelihood of higher growth than any other country for the next 10-20 years and that no one really knows how much influence the government has on the Chinese market (weak-form EMH). Mandelbrot argues that data fed into the market is represented purely by chance. Prices go up and down just like flipping a coin. If an investor buys low, s/he gains; if one buys high, s/he loses. If a big event occurs, the market stops trading temporarily, and then continues with time. Based on Malkiel and Mandelbrot interviews, I think the security markets adjust prices based on data and events where ultimately risk must be managed. Sometimes market seems efficient, adjusting to the new information. But, other times, it seems uncertain – which may be due these “events”.

  7. Mickie Nuss
    May 3, 2010 at 5:21 pm

    I think the MS-FAIM students are biased and believe that they will be able to outperform the market because their livelihood depends on it. I prefer the efficient approach presented by Milkiel, passive investing in an index fund. With all the daily activities and stress I already have in my life I do not need to worrying about trying to outperform the market. I am going to continue to stash away a percentage of my salary into my 401-K and IRA every month for the next 40 years and then retire and go fishing.

  8. Heather Case
    May 6, 2010 at 8:14 pm

    After watching the interviews, I think that market efficiency is not always as predictable and formulated as some perceive it to be. Here you have two so called “champions” in their field who view investment strategy through different telescopes. I personally think certain investments can be calculated in the bigger picture but there are many times where unpredictable issues or events arise and our investments fluctuate positively or negatively as a result and this is not in our control. Sometimes risk can be controlled and yield beneficial fluctuations, but then again sometimes those that seem able to control their risk either go bankrupt or go to jail. Malkiel’s perception suggests a more diversified attitude and long term strategy towards investment and I think that is the safest avenue for investment.

  9. Matt Tozi
    May 6, 2010 at 9:43 pm

    I like Malkiel’s advice to put money in a global index fun, weighted heavily on China. China and other emerging markets offer great returns, but one has to be willing to accept the risk as well. As my peers have pointed out, it is odd that Malkiel would push China since they have government control over business/markets-however, issues such as that are part of the risk that can/do bring the higher return from emerging markets. Plus many areas of China are becoming increasinly capitalistic. I respect Mandelbrot’s theory, but I prefer Malikiels efficient market approach.

  10. Rosangel Ron
    May 7, 2010 at 11:28 am

    Based on these two interviews, I agree with Malkiel that one must invest in passively managed index funds which are not traded often (helps avoid the transactions fees as well). The small portfolio projects done in school have proved that randomly picked stocks and the returns earned are mostly luck; whether they are positive or negative. Investment in emerging markets, such as China, could be a wise move as it will most likely be the fastest growing nation in the next 10-20 years.

  11. Jill Kitchin
    May 7, 2010 at 1:07 pm

    Malkiel believes investors are better off with passively managed index funds that have low expense ratios and do not trade compared to actively managed funds. Mandelbrot believes the market is pure luck and as random as the flip of coin. I tend to lean towards Mandelbrot’s opinion that it is pure luck as prices can change due to the occurrence of major events, laws, regulations, and errors that are not already factored into the price which can cause the price to skyrocket or drop significantly. Yesterday the U.S. equity market plunged due to human errors. The DJIA was down as much as 998.5 points mid day, finally closing at 347.80 points. Speculation suggests that a trader entered an erroneous error of $1B instead of $1M. Traders on the floor were able to halt further errors due to this drop, but electronic trading (such as done at major broker dealers) kicked in limit orders that sold automatically. After the down markets of the last couple years, many investors re-entered the markets with limit orders on their stocks to avoid huge losses if the market were to plunge like it had before. Therefore, one error made by a trader such as in this situation with limit orders in place, causes the entire market to crash. While an investor can use reasonable facts based on market trends and history, there is always the chance of uncontrollable events (i.e. “luck”) because of human interaction with the market (basic data entry error and unknown events) that can cause change in prices not already reflected in the markets.

  12. Michael Cotter
    May 7, 2010 at 3:15 pm

    Speculation or mathematical probability? Luck or Skill? These are some of the questions that come to mind when deciding whether the market is efficient or not. Malkiel would argue that, for the most part, markets are efficient. He believes that investors are better off investing in passive index funds versus those that are actively traded stocks. He makes a good arguement that the returns of the passively have surpassed those of activily traded stocks in the long run. Malkiel believe that investing in China is the way to go for the next one or two decades. I find this contradictory to his arguement that markets are efficient. Although, he breifly addresses the concerns with the exchange rates and governement control within the Chinese markets, he does so in a very passive manner. The basis of market efficiency is transparency, which is nearly non existant in the Chinese markets. Going as far as to say invest heavily into a market with little transparency appears to be more based on speculation rather than statistically derived theory. Mandelbrot, on the other hand states that data fed into the market place is done so by investors acting with pure chance, like that of flipping a coin. After watching the two speakers and adding a little of my own bias, I have become very skeptical of market efficiency. I do not believe that pure market efficiency has ever existed within the stock market. However, I do believe that the increase in people with access to the ability of investing within the markets has cause a great deal of murkiness within the water. By this I mean that the average person wants to jump into the next “google type investment” and jump out. Knowing this investment banks, who may hold a great deal of stock in a pre IPO company, will send their analysts out to act more like salesman on television programs. Another example of the manipulation within the markets is that of the Goldman Sachs scandal or even Enron. I believe that the markets have slipped away from efficiency over the past decade. The casino culture of Wall Street has taken over in the last few decades. Enron is a prime example of this, they bluffed and no one called them on it so they took the pot time and time again until they were forced to show their hand. It was John Maynard Keynes that said it best, “It is generally agreed that casinos should, in the public interest, be inaccessible & expansive. And perhaps the same is true of the stock exchanges.”

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