Markets Can Do Many Things Well, But Not Everything

Last Updated Aug 5, 2009 7:20 AM EDT

Eric, I'd agree with you that a command-and-control economic system run entirely by bureaucrats would be a really bad thing. But that's really beside the point. The reality is, our system is a mix of government edicts and freely functioning financial markets, and it broke down. The system we'll end up with in its place will be yet another mix of edicts and markets. The challenge we face is figuring out what kind of structure and rules make the most sense when we know that financial markets are prone to occasional manias and panics -- but also know that government decision makers are subject to their own litany of biases and flaws.

Financial markets can do lots of great things -- gather dispersed information, change direction quickly, reward the industrious and quick-witted. What they can't do is keep themselves from losing their moorings from time to time. This reality is why over the past two centuries we've developed central banks and financial regulations. Yet it is a reality almost completely ignored by the efficient-market approach to finance.

The housing bubble was driven by the market
Certainly, as you write, Washington's decades-long push to make housing more "affordable" contributed to the mortgage crisis. But if private investors in freely functioning markets hadn't been willing to buy all those mortgages, the housing bubble could never have gotten so big. At the height of the real estate insanity, from 2004 to 2006, the mortgage market was dominated by private securitizers who shoved the FHA, Fannie Mae, and Freddie Mac aside. While it's true that government actions enabled the bubble -- in fact, the 30-year mortgage is a New Deal-era government creation -- its greatest excesses were the work of the markets.

I'll be honest: I don't know what exactly the new rules should be. There's a lot of appeal to the argument that reducing leverage should be the main priority, because a financial system built on debt is inevitably more fragile than one that is not. There are also lots of ways to get around and game leverage restrictions, though. In any case, just saying that markets are better decision makers than governments and leaving it at that isn't very helpful.

Lessons for investors
For the purposes of MoneyWatch readers, though, let's move our discussion to the implications of the efficient market saga for investors. The big lesson that came out of the confluence of the efficient market hypothesis and the capital asset pricing model (which holds that stocks with higher sensitivity to market fluctuations will deliver higher returns) was that you should hold a widely diversified portfolio, preferably in some kind of index fund. Now that it's clear that either the efficient market hypothesis or the capital asset pricing model -- or both -- don't square with reality, the lessons would appear to be more complicated. I've stuck mostly with index funds out of a continuing belief in Jack Bogle's "cost matters hypothesis," which states that:
No matter how efficient or inefficient markets may be, the returns earned by investors as a group must fall short of the market returns by precisely the amount of the aggregate costs they incur. It is the central fact of investing.
So I invest in index funds not because I think the market is all that efficient, but because index funds charge the lowest fees. If cost matters so much, though, then the cost of the stocks I'm buying (the price-to-earnings or price-to-book ratio) probably matters, too. Maybe my passive approach isn't optimal. I know these topics have been occupying you, too -- you've got a wonky new book out, Finding Alpha: The Search for Alpha When Risk and Return Break Down, that addresses them. So what have you got for me, Eric?

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    David Hamilton is the assistant managing editor of CNET News. He has been writing and editing business and tech coverage for about two decades -- the majority of that at the Wall Street Journal in both Tokyo and San Francisco. He is a two-time winner of the Overseas Press Club award and has written for numerous magazines and blogs, including Slate, Science, VentureBeat, CBS Interactive's BNET, California Lawyer and the New Republic.