If you're so smart, why aren't you rich?
"If you're so smart, why aren't you rich?" Most Finance professors have
faced this question at some point. The obvious answer is, of course,
that in efficient capital markets, Finance professors are not necessarily
any better off than anyone else. Over the years, I have found that discussions
of the EMH are likely to be the some of the most memorable and fruitful
discussions of the entire semester.
In the context of corporate finance, the notion of market efficiency is
particularly important - if capital markets are not efficient at least in
the semistrong-form sense, then market prices do not impound publicly
available information; if that were the case, how could we justify our
reliance on the "golden rule" of corporate finance: Maximize shareholder
wealth"?
Here are two ways to motivate a discussion of market efficiency. First, point out the
difficulty professional money managers experience in "beating the market".
The difficulty of this task is highlighted in a series of recent articles
in The Wall Street Journal, as well as a cover story in the June 9, 1997
issue of Fortune, entitled "Has Fidelity Lost It?". The reasons for
the lackluster performance of many of Fidelity's funds over the last several
year are varied; interestingly, the June 4th issue of The Wall Street Journal
even suggests that the firm's flagship fund, Magellan, has shadowed (but under-performed)
the S&P 500 over the last twelve months. In any event, what I stress in
discussing the widely-documented inability of professionals to outperform the market
on a risk-adjusted basis, is that, despite (or perhaps because of) the
resources, intelligence, and skills focused on generating portfolio returns,
the capital markets can hardly be anything but efficient.
Additionally, one might argue that the continued growth of "index funds" - passively
managed portfolios designed to mirror some broad market index such as the DJIA or
the Russell 3000 - is prima facie evidence of market efficiency. At this point,
approximately 11 percent of the money invested in stock funds in the U.S. is invested
in index funds; not bad, considering that index funds have only existed in their
current form for less than two decades.
In short, while students may or may not 'take our word for it', the evidence for informational efficiency
(or some approximation thereof) is compelling. And as a result, we as Finance
professors have a decision rule that is a useful prescription for managerial
decision-making.
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