Tuesday 18 September 2007

Are finance professors overconfident?

I wasn't going to post this week, as I have a couple of other things on. However, this paper arrived in my inbox and I couldn't resist the urge to flag it up to you. Professors Doran, Peterson and Wright survey the academic finance communities attitudes towards market efficiency and investing.

They manage to get around 700 usable responses (a high response rate for such a survey). Doran et al first asked the professors for their beliefs on market efficiency. In academic finance there are 3 levels of efficiency (weak, semi-strong and strong form efficiency). Each corresponds to the amount of information that is incorporated within prices. Weak form efficiency says you can't beat the market using just past prices, semi-strong form says that both past prices and public information are already reflected in the prices. Strong form efficiency says that all information both public and private is reflected in the current price.

The chart below shows the percentage of respondents agreeing (blue bars) or disagreeing (cream bars) with the statements that future returns can be forecast from (i) past returns (weak form), (ii) past returns and public information (semi-strong form) and (iii) past returns and public and private information (strong form).

Nearly 60% of the professors accept that the US market is weak form efficient (i.e. ignoring the enormous literature on momentum as a stock selection tool, incidentally something I am guilty of as well).

One third of the them accept that the US market is semi-strong efficient (i.e. that value strategies don't work since they involve publically available information such as earnings or book value).

Only when it comes to strong form efficiency do we finally see the academics reject the concept on efficiency. Some 57% said it was possible to predict future returns when using private information.

Two other questions of interest were raised in the survey. The first concerned whether the professors agreed that returns were a compensation for risk (i.e. the multi-factor world of Fama and French - a rejection of behavioural finance). Only a mere 27% of the professors disagreed with this statement. So we behaviouralists are definitely in a distinct minority in academic circles.

The other question concerned whether the professors thought that investment strategies that could consistently beat the market without taking above market risk actually existed. Only 17% of the respondents said yes such strategies existed. So academia seems to remain a bastion of market efficiency and passive investing. When asked, just 18% of the professors said their objective was to outperform the index.

There was one final finding from the survey which made me laugh (I know I'm sad). Doran et al found that finance professors decisions to actively invest were largely independent of their beliefs in market efficiency. Instead they reflected professors confidence in their abilities! As Doran et al note "A professor’s opinion on the general efficiency of US stock markets has little influence on his investment objectives relative to his confidence in his own abilities. Within confidence groupings, there is little dispersion in a professor’s investment goals as his opinion of market efficiency changes. However, within the opinion groupings , there is a substantial amount of near monotonic dispersion in a professor’s investment goals as his confidence in investing abilities changes. This suggests that a respondent’s opinion of market efficiency has little to do with his decision of whether to actively or passively invest. What matters is an investor’s confidence in his own abilities."

Sounds like finance profs are just like the rest of us - human after all!


Anonymous said...

Hi James,

Just a very brief note, I've been trying to get an email address for you without much success.

I run a website called MoneyScience at www.moneyscience.com. I've included this blog in the finance blogs section but I'd very much to like to syndicate the RSS headlines also.

Feel free to contact me: jacob@moneyscience.com

Thanks for your time.

Karl Smith said...

I would note that I interpret EMH as saying there is no systematic way of beating the market using prices, public or all information respectively.

It is entirely possible that someone beats the market using intuition or irreplicatable genius, since there is no way to arbitrage those abilities out.

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