The HS Dent Financial Blog

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The (In)Efficient Market

Most money managers in the business today were taught in business school that the market is “efficient,” meaning that are meaningful information is already factored into the current stock price.  The implications are that the current price is the “correct” price, the market is never wrong, and there is no value to doing financial analysis or to buying anything other than a passive index fund.Of course, few of those managers actually believe in the efficient market hypothesis, or they would have found a different line of work. 

Warren Buffet had this to say about the notions that market are efficient:“Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.”

“It has been very helpful to me to have tens of thousands turned out of business schools taught that it didn’t do any good to think.”

We agree fully.  In our own Risk, Return, and Reality, we made our case that the tenets of the efficient market hypothesis did not hold.  Price movements are not random and independent; they tend to trend and influence one another.  Volatility is not constant; it tends to cluster.  Anyone who doubted that in the past would surely agree today based on the experience of 2008.   From the beginning of the bear market October 2007 until this week, we suffered through nearly as many high-volatility days (defined here as a day in which the Dow moved 2% or more) than during the entire decade of the 1990s!

This week, The Economist wrote:

The past ten years have dealt a series of blows to efficient-market theory, the idea that asset prices accurately reflect all available information. In the late 1990s dotcom companies with no profits and barely any earnings were valued in billions of dollars; and in 2006 investors massively underestimated the risks in bundling together portfolios of American subprime mortgages.  There is now widespread acceptance that investors can behave irrationally, creating very large anomalies.   

Large anomalies indeed.  If this crisis does not put the nail in the coffin of the efficient market hypothesis, then it is hard to imagine what will.