EMH isn’t wrong,
it’s just incomplete
Gordon Pepper, CBE, FIA, FSIP, explains the problems with
the effi cient market hypothesis and argues that it should be
complemented with the liquidity theory of asset prices
BY: GEORGE PEPPER, CBE, FIA, FSIP
contrary to conventional academic theory. Two theories dominated
I
n February, Anatole Kaletsky wrote a academic thinking: Modern Portfolio Th eory (MPT) and the
column in Th e Times, under the Effi cient Market Hypothesis (EMH). Unfortunately, they provide a
headline ‘Economists are the woefully inadequate explanation of the behaviour of fi nancial
forgotten guilty men’, in which he markets in the past.
said: “Academics – and their mad theories I was by no means alone at being critical of academic thinking.
– are to blame for the fi nancial crisis. Th ey
too deserve to be hauled into the dock... LIQUIDITY THEORY
the academic theorists who win Nobel In 2002, the trustees of the Stewart Ivory Foundation decided to
prizes, or dream of winning them... in sponsor a foundation course in investment (subsequently part of
particular their two theories – called the Approved Provider Program of the CFA Institute). Liquidity
‘rational expectations’ and ‘the effi cient was identifi ed as one of the crucial omissions and I was invited to
market hypothesis’... on two dubious cover this subject. A book, Th e Liquidity Th eory of Asset Prices, by
adjectives ‘rational’ and ‘effi cient’ an Gordon Pepper with Michael J Oliver, followed.
enormous theoretical superstructure of First, it must be appreciated that EMH and MPT, correctly
models, regulatory prescriptions and stated, are not wrong. Th ey are merely incomplete. A much fuller
computer simulations was built. Th ere explanation of the behaviour of fi nancial markets is obtained if
seem to be only two options. Either the they are complemented by the Liquidity Th eory of Asset Prices
subject has to be abandoned as an (LTAP). But notice the qualifi cation ‘correctly stated’.
academic discipline and becomes a mere EMH, correctly stated, is that investors cannot outperform a
appendage of the collection and analysis market consistently making use of existing available information.
of statistics. Or it must undergo an Investment managers should at least agree that it is extremely hard
intellectual revolution. Th e academic to do so. EMH does not state that the stock market is effi cient in
Establishment will resist such a shift, as it the sense that prices correctly reflect the factors considered to be
always does. But luckily economists important by fundamental analysts and industrialists. Th is is a
understand incentives. Th ey should now deduction from EMH that may, or may not, be correct.
be given a clear choice: embrace new ideas Most investors are adverse to taking risk. If they are off ered
or return their public funding and Nobel two stocks with the same expected return they will choose the one
prizes, alongside the bankers’ bonuses they with the minimum risk of adverse outcome. Th e adverse outcome
justifi ed and inspired.” can be either relative to a target index, peer group or outright loss.
20 years ago I left the sharp end of the Th ey will want a higher expected return if they are to invest in the
City, having been widely acknowledged as riskier stock. Th e first principle of investment is hence “to
the guru of the gilt-edged market, to join maximise the expected return with the minimum of risk”. Many
City University Business School (now academics, wrongly focus mainly on volatility rather than on risk
Cass Business School) to pass on to others of adverse outcome (the founder of MPT, Harry Markowitz, did
what I had learnt in markets that was not make this mistake; he wanted to use semi-variance).
20 SUMMER 2009
20-2320-23 EMH.indd 20EMH.indd 20 2/6/092/6/09 14:11:2714:11:27Professional Investor Summer 09.22 22 4/6/09 15:40:51
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