[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

subsides. Thus, if a person knows that economic analysts are predicting lower
inflation, she will not expect the gold price increases to continue. Even when individuals
form their expectations rationally, they will not be right all the time. Sometimes
they will be overly optimistic, sometimes overly pessimistic (although in making
their decisions, they are aware of these possibilities). But the assumption of rational
expectations is that on average they will judge correctly.
The 1970s was a decade when adaptive expectations reigned. Many investors
came to expect prices of assets such as land and housing to continue to rise rapidly.
The more they invested, the more money they made. The idea that the price of a
house or of land might fall seemed beyond belief—even though history is full of
episodes (most recently in Japan during the 1990s) when such prices fell dramatically.
The weak real estate markets of the 1980s in many regions reminded investors
of the importance of incorporating historical data in forming expectations.
But in this, as in all types of fortune-telling, history never repeats itself exactly.
Since the situation today is never precisely like past experience, it is never completely
clear which facts will be the relevant ones. Even the best-informed experts
are likely to disagree. When it comes to predicting the future, everyone’s crystal ball
is cloudy.
Efficient Market Theory
The demand for any asset depends on all four of its basic attributes—
average return, risk, tax treatment, and liquidity. In a well-functioning
market, there are no bargains to be had: you get what you pay for. If some
asset yields a higher average return than most other investments, it does
so because that asset has a higher risk, is less liquid, or receives less
favorable tax treatment.
That there are no bargains does not mean the investor’s life is easy.
He still must decide what he wants, just as he does when he goes into a
grocery store. Figure 39.5 shows the kind of choices he faces. For the
sake of simplicity, we ignore liquidity and tax considerations and focus
only on average returns and risk. The figure shows the opportunity set
in the way that is usual for this case. Because “risk” is bad, to get less
risk we have to give up some average returns. That is why the trade-off
has a positive slope. We can see that assets with greater risk have a
higher average return. Point A represents a government T-bill—no risk
but low return. Point B might represent a stock or mix of stocks of average
riskiness; point C, a stock or mix of high risk. A very risk-averse
person might choose A; a less risk-averse person, B; a still less risk-averse
person, C.
The theory that prices perfectly reflect the characteristics of assets—
there are no bargains—is called the efficient market theory. Since much
of the work on efficient market theory has been done on publicly traded
stocks, our discussion centers on them. The lessons can be applied to
all asset prices, however.
AVERAGE RETURNS
A
Figure 39.5
B
Risk-return
trade-off
RISK
THE RISK-RETURN TRADE-OFF
To get a higher expected return, an investor must
accept more risk.
C
EFFICIENT MARKET THEORY ∂ 881