An MIT Professor Explains His Original Theory For How Markets Really Work

Tracy Alloway (0:09)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:13)

And I'm Joe Weisenthal.

Tracy Alloway (0:15)

Joe, what did you study at college?

Joe Weisenthal (0:19)

I'm already nervous about answering this question because I actually genuinely don't know where you're going with it.

Tracy Alloway (0:25)

Well, I also don't know what you studied, so I'm genuinely curious.

Joe Weisenthal (0:30)

I studied international relations. Actually, I went at University of Texas. They called it government, which is not really a thing anywhere else, but it was kind of like their political science department, but I focused on international relations.

Tracy Alloway (0:42)

Okay, I swear this is a complete coincidence, but I also studied international relations.

Joe Weisenthal (0:48)

Really? That's funny that, like, of all this time I've known you, this has never come up.

No, seriously, like, for people who think, who are listening, who think maybe we're faking this or something, it's actually... I genuinely did not know that about you.

Tracy Alloway (1:00)

Now people are thinking that we just never talk to each other outside of this podcast.

Joe Weisenthal (1:04)

We just only talk markets. No personal stuff.

Tracy Alloway (1:07)

The reason I was bringing it up was because I was trying to think of a parallel with what we're going to speak about in just a few minutes. And I was thinking, you know, in international relations, there are these two dominant theories that govern how you think about the world. They're realism and liberalism. Do you remember that?

Joe Weisenthal (1:28)

I'm glad you didn't ask me to name them. I would have remembered realism, and I would have blanked on the other one. But yes, that sounds right.

Tracy Alloway (1:34)

Okay, so realism is this theory that states and governments and people are essentially self-interested, and, you know, everyone's out to get each other. And liberalism is, oh, actually, we can all get along, and there's scope for cooperation. Two diametrically opposed theories that completely govern that particular study. Now, the reason I'm bringing it up is because we are going to talk about a similar parallel in economics.

Can you guess what it is?

Joe Weisenthal (2:04)

Why don't you just tell me?

I mean, I think I know where it's going, but I really like the way you're taking this. All right.

Tracy Alloway (2:11)

So it's the efficient market hypothesis versus behavioral economics.

Yes. Okay. So most people probably know this, but the efficient market hypothesis basically says that you can't beat the market, that it's a perfect reflection of the information currently out there and a perfect reflection of the price that you should be paying for that information. Meanwhile, behavioral economics basically suggests that human beings can be irrational and we can get stuff wrong, and that means that markets also can be irrational and can get stuff wrong. So two pretty much diametrically opposed schools of thought.

Joe Weisenthal (2:52)

So are we going to find out which one is correct today?

Tracy Alloway (2:58)

We're actually going to talk to someone who thinks they found a middle path between those two seemingly opposed schools of thought.

Joe Weisenthal (3:09)

I'm intrigued. So who are we talking to and what's their theory?

Tracy Alloway (3:12)

Okay. I'm really excited to bring on Andrew Lo. He's an economist. He's a long time MIT professor, and he's written, well, he's written several books, but most recently he has written a book on exactly this topic.

Andrew, thank you so much for joining us.

Andrew Lo (3:38)

It's a pleasure. Thanks for having me.

Tracy Alloway (3:40)

So just going back to the efficient market hypothesis, I gave a little snapshot of it, but maybe you could describe it a little bit more, and also perhaps explain how it came to be a fundamental tenet of modern financial theory, when everyone seems to beat up on it nowadays.

Andrew Lo (4:02)

Sure, well, you know, it's a really interesting idea, and it's the brainchild of two economists. Gene Fama at the University of Chicago coined the term and came up with the basic idea that in an efficient market, prices fully reflect all available information. And so if that's the case, then you really can't beat the markets by using information because it's already in the price.

And Paul Samuelson was the other economist who contributed to this theory, and his paper was titled Proof that Properly Anticipated Prices Fluctuate Randomly, which is a very fancy way of saying that once you incorporate all available information into prices, you don't know where it's going to go. So you can't predict future prices based upon where it is today.