Rational Expectations and Efficient Market Hypothesis

The rational expectations (RE) hypothesis is an assumption used to derive the expectations term of a model: it claims that agents expectations of the future value of economically relevant variables are not systematically wrong or based on irrelevant or otherwise stale data, and thus that all errors are random. The intuition is that if this wasnt the case, profit opportunities would exist, which would be exploited, until the RE is restored. RE is a necessary condition for the Efficient Markets Hypothesis (EMH) to hold: EMH states that financial markets are informationally efficient, in the sense that all the available information is incorporated into the price, making it impossible for individuals to consistently achieve aboveaverage market returns on a risk-adjusted basis. The intrinsic economic value of a security is thus equal to the sum of its future cash flows discounted to the present by the appropriate cost of capital: ( )

According to the formulation above, the only factors that could lead to a change in price are changes in the expected future dividends, and changes in the discount rate. These are assumed to be unpredictable, otherwise they would already be factored into the price. Hence prices follow a random walk process whereby , and price changes, which arise from the incorporation of new information into the price as it becomes available, are random variables with mean zero. Shleifer: the basic theoretical case for the EMH rests on three arguments which rely on progressively weaker assumptions: 1. Investors are assumed to be rational and hence to value securities rationally; 2. To the extent that some investors are not rational, their trades are random and therefore cancel each other out without affecting prices; 3. To the extent that investors are irrational in similar ways, they are met in the market by rational arbitrageurs who eliminate their influence on prices. Biological argument: an arbitrageurs gain comes at the expense of an irrational investor. Since they cannot lose money forever, they will gradually be pushed out of the market. The EMH can be rationalized both ex-ante and ex-post. The ex-ante argument is a no-arbitrage condition, whereby market prices must reflect all available information. Ex-post, we can test empirically whether securities prices follow a random walk. By and large, this appears to be the case in the data, with limited evidence of autocorrelation or heteroscedasticity. In turn, this result has important implications for investment theory: if EMH holds continuously, active investment management becomes redundant and the best investment strategy is to track the market. Although evidence in this sense is inconclusive, Busse, Goyal and Wahal find no evidence of superior performance of active investment management either in aggregate or on average.

Criticism
Empirical Anomalies The empirical anomalies literature is one of the main sources of criticism of the EMH. Numerous biases have been observed in price movements, such as the January bias, the small firm bias, the winners and losers bias and PE effects. Bouman and Jacobsen find evidence of sell in may and go away effect Another popular criticism is that advanced among others by Shiller, who points out that the volatility observed in prices is inconsistent with changes in fundamentals. This anomaly is likely to arise once again from market structure: investment decisions are often delegated to asset managers and pension funds, who may be responding to a set of personal incentives. Passive investment funds may trade to keep up with changes in credit rating and in the underlying index, while active investment managers may suffer from an activity bias. Furthermore, brokers are compensated on trading volume and as such they have incentives to encourage trading.

Individuals are not the only investors whose trading strategies are difficult to reconcile with rationality. Professional money managers manage much of the money in financial markets, and besides being human, they also suffer from further distortions arising from the principalagent relationship. For example, professional managers may choose portfolios that are excessively close to the benchmark that they are evaluated against, to minimize risk of underperforming their benchmark. They may also herd and select stocks that other managers select, to avoid falling behind. In the short run, it may be advantageous for an agent to herd, rather than to elaborate original trading strategies which are not going to perform immediately (Keynes: the market can stay irrational for longer than you can stay solvent). Behavioural Finance Another stream of criticism follows the seminal work of Kahneman and Tversky, who pointed out how heuristics used by the human mind can lead to predictable deviations from rationality. Individuals suffer from excessive optimism, framing biases, loss aversion and self-attribution biases, which are likely to lead to herding behaviour.

Discussion
Assumptions in economics are often unrealistic, and this is surely the case with RE. However, the crucial question is whether this approximation leads the model to materially different conclusions that would otherwise be obtained. We have previously examined a number of different sources of criticism towards the EMH. The first stream of criticism focuses on empirical anomalies observed in the data. However, these anomalies should be treated with caution, since their persistence varies considerably and they do not unambiguously lead to profit opportunities once risk and transaction costs are taken into account. These anomalies arise mainly from market microstructure, and do not dent significantly the EMH argument. Another stream of criticism focuses on heuristics used by individual investors and on the consistent deviations from perfect rationality that the resulting biases lead to. Overall, however, it is not clear to what extent this evidence dents the EMH argument. Assuming that the same dynamics of irrationality hold in the same manner at the individual and at the aggregate level may suffer from fallacy of composition issues. In other words, it is not clear that in order to have efficient markets it is necessary for individual investors to be perfectly rational. As long as markets reward rational participants, there are incentives for investors to strive for rationality, albeit imperfect. Overall, while there is ex-post evidence that long-run price changes follow a random walk process, this is at odds with price movements observed in the short run. Extrapolation from past data, as well as temporary demand and supply imbalances are likely to create short-run price deviations from fundamentals. Feedback loops and herding behaviour (remember Citis Chuck Prince one has to dance till the music stops) can compound these deviations, leading to boom and bust cycles. However, asset prices appear to be more or less consistent with predictions from the EMH in the long run. Another strong argument in favour of EMH is the lack of credible alternatives to this framework. The static expectations framework conceptualizes expectations of the future as arising from past information; however, while there is undoubtedly an element of inertia in most economic variables, it is unclear what such a formulation contributes to our understanding of financial markets. It is clear that while price levels are typically backwardlooking, price changes are forward-looking. Hirshleifer: The great missing chapter in asset-pricing theory, I believe, is a model of the social process by which people form and transmit ideas about markets and securities. In addition to studying what influences individuals valuations, an appealing direction is to study how attention is focused on certain groups of stocks, and the effects of resulting swings in participation. A different empirical direction is to analyze the specific content of widespread, erroneous investor theories to identify ways of predicting returns.