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ECON-252-11: FINANCIAL MARKETS (2011)

Lecture 7 - Efficient Markets [February 7, 2011]

Chapter 1. Swensen's Lecture in Retrospect and Manipulations of the Sharpe Ratio [00:00:00]

Professor Robert Shiller: And I want to talk today about efficient markets, which is a theory that is a half-truth, I will say. Before I start, I wanted to just give a few thoughts about David Swensen's lecture last period. Let me say, first of all, the Efficient Markets Hypothesis or the Efficient Markets Theory is a theory that markets efficiently incorporate all public information. And that, therefore, you cannot beat the market, because the market has all the information in it. You think you're smarter than the market, that you know something? No, the market knows more than you do. And you'll find out that the market wins every time. That's the Efficient Markets Hypothesis. So, it's a very far-reaching hypothesis. It means that, don't even try to beat the market. That was a very rudimentary introduction to today's lecture.

But here I brought in David Swensen, who is claimed to have beaten the market consistently since 1985, and dramatically. And so, what do we make of that? That's the subject of today's lecture. By the way, after class one of you came up — thank you, it was nice, I don't know where you are — one of you came up and thanked Swensen for his scholarship at Yale. Yale now has need-blind admissions for the world. And so people, not just from the United States, people are helped out, so that people who have managed to meet the high admission standards here, makes it possible for them to actually come here. And that's substantially David Swensen who did that, because it's not just the generosity of the university. They have to have the money to do it. And so, somehow he seems to have made it.

Now, I know that there are still many cynics — the Efficient Markets Hypothesis has a lot of adherents still. And as I say, it's a half-truth. So, some people will say, well, Swensen was just lucky. And I say, how could he have been lucky for 25 years in a row? Well, not every single year, but pretty much. And they say, well, you're picking the one guy out of millions who is just the luckiest. So, those arguments are made. Anyway, one of you asked a question, which I thought it was very good, at the end. And that is why, in all of my discussion about Swensen and all of his talk he never mentioned the Sharpe ratio? Because as we said, the Sharpe ratio corrects for risk taking. That was one of our fundamental lessons. When we showed you the Efficient Portfolio Frontier, and the tangency line. You can get any expected return you want at the expense of higher uncertainty. You do a very risky portfolio, and you have high-expected return, because of the risk. If the risk is measured right.

But I think that's a good very good question. I caught myself not correcting for it, I just said Yale's portfolio had a high return. I didn't correct for standard deviation of return. So, David Swensen, in his answer, as you recall, essentially said he doesn't believe in Sharpe ratios, because we can't measure the standard deviation. The Sharpe ratio is the excess return of a portfolio over the market, divided by the standard deviation of the return. And that scales it down, so if the excess return is very high but also has a very high standard deviation, that shows they were just taking risks. And so the Sharpe ratio would reveal that.

Lecture 7 - Efficient Markets [February 7, 2011]

Chapter 1. Swensen's Lecture in Retrospect and Manipulations of the Sharpe Ratio [00:00:00]

Professor Robert Shiller: And I want to talk today about efficient markets, which is a theory that is a half-truth, I will say. Before I start, I wanted to just give a few thoughts about David Swensen's lecture last period. Let me say, first of all, the Efficient Markets Hypothesis or the Efficient Markets Theory is a theory that markets efficiently incorporate all public information. And that, therefore, you cannot beat the market, because the market has all the information in it. You think you're smarter than the market, that you know something? No, the market knows more than you do. And you'll find out that the market wins every time. That's the Efficient Markets Hypothesis. So, it's a very far-reaching hypothesis. It means that, don't even try to beat the market. That was a very rudimentary introduction to today's lecture.

But here I brought in David Swensen, who is claimed to have beaten the market consistently since 1985, and dramatically. And so, what do we make of that? That's the subject of today's lecture. By the way, after class one of you came up — thank you, it was nice, I don't know where you are — one of you came up and thanked Swensen for his scholarship at Yale. Yale now has need-blind admissions for the world. And so people, not just from the United States, people are helped out, so that people who have managed to meet the high admission standards here, makes it possible for them to actually come here. And that's substantially David Swensen who did that, because it's not just the generosity of the university. They have to have the money to do it. And so, somehow he seems to have made it.

Now, I know that there are still many cynics — the Efficient Markets Hypothesis has a lot of adherents still. And as I say, it's a half-truth. So, some people will say, well, Swensen was just lucky. And I say, how could he have been lucky for 25 years in a row? Well, not every single year, but pretty much. And they say, well, you're picking the one guy out of millions who is just the luckiest. So, those arguments are made. Anyway, one of you asked a question, which I thought it was very good, at the end. And that is why, in all of my discussion about Swensen and all of his talk he never mentioned the Sharpe ratio? Because as we said, the Sharpe ratio corrects for risk taking. That was one of our fundamental lessons. When we showed you the Efficient Portfolio Frontier, and the tangency line. You can get any expected return you want at the expense of higher uncertainty. You do a very risky portfolio, and you have high-expected return, because of the risk. If the risk is measured right.

But I think that's a good very good question. I caught myself not correcting for it, I just said Yale's portfolio had a high return. I didn't correct for standard deviation of return. So, David Swensen, in his answer, as you recall, essentially said he doesn't believe in Sharpe ratios, because we can't measure the standard deviation. The Sharpe ratio is the excess return of a portfolio over the market, divided by the standard deviation of the return. And that scales it down, so if the excess return is very high but also has a very high standard deviation, that shows they were just taking risks. And so the Sharpe ratio would reveal that.

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