January 22, 2015

Nothing orthodox about belief in efficient financial markets

We should not call the efficient markets theory economic orthodoxy. It is a theory that originated in the Chicago school of economics - a very particular instituion whose theories are often regarded as highly controversial by economists - that (at least s far as the pensions industry is concerned) has turned the minds of part of the actuarial profession. Some of them have discovered that it is a way of avoiding some of the problems that have befallen the profession in the past for which they have been criticised. Adopting a strict mark-to-market approach to valuation assuming markets are inherently efficient is a perfect route to a successful actuarial career if you can carry the trustees and stakeholders along with you (by telling them it is orthodoxy). You can then take all the credit for success while having a perfect cop-out for failure ('it wasn't due to my failure of judgement it was the market').

You don't have to be an anti-capitalist to criticise it. Here is what Warren Buffett thinks about it (this is just a flavour):


There is much criticism of it revealed by the merest googling. There are many articles in the financial press and also in the economics literature. Here is one in today's Telegraph online:


This article says: "So, increasingly few people still believe that markets are wholly efficient and that is a good thing. "

Unfortunately Bill Galvin i(USS chief executive) seems to be one of them. This is what he recently wrote in a letter: "...the RPI inflation assumption is derived relative to the implied market expectations for future inflation levels ... the trustee feels it is appropriate to use an objective measure such as this as a starting point rather than trying to otherwise predict future changes." (My emphasis)

He interprts the data according to his theory of how expectations are formed by market participants, hence they are 'implied' and the results he gets are 'objective' (they are actually the result of behaviour by human beings which is what a market is).

This is blind faith. Suppose the market is affected by 'irrational exuberance' or randomness of some form. By interpreting the data according to the theory to get so-called objective measures he will go badly astray.

Maybe we are witnessing this already in the high volatility of the valuation.

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