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Stating the Obvious: Markets Are Not Rational

I hate criticising the CFA Institute because, as a charterholder, I end up inadvertently bashing myself. Still, the organization’s historical commitment to the Efficient Market theories has always been frustrating to me. The CFA Institute counts among its members some of the brightest minds in finance…yet much of its curriculum supports a theory that has been proven time and again in the real world to be patently false and unrealistic. Belief in the efficiency of markets given the series of meltdowns over the past decade is almost as crazy as continuing to believe in communism as an economic model given the failure of the Soviet Union.

We do have cause for hope, however. Writing in the Financial Times, Gillian Tett tells us that “Credit crunch causes analysts to rethink rational market theory“

Ms. Tett writes,

For the past five decades, the Chartered Financial Analyst Institute has been teaching the tenets of analysis based on efficient markets to tens of thousands of adherents from banks, fund managers and investment houses that make up the global financial system.

Now, however, the credit crisis has forced high priests of rational market theory to question their own creed.

Ms. Tett relates a survey by the British CFA society in which members were asked their opinions of the Efficient Market Hypothesis. The results show that “77 per cent of the group “strongly” or “very strongly” disagreed that investors behaved “rationally” - in apparent defiance of the “wisdom of crowds” idea that has driven investment theory.”

We’re going to have to stop Ms. Tett for a moment. The expression “Wisdom of Crowds“ was made famous by James Surowieki’s book of the same name and should be explained here.

The Wisdom of Crowds is NOT a mindless, glassy-eyed defense of Efficient Markets theory, as I feared it would be when I first picked it up. It’s actually a highly-intelligent discussion of when and where crowd “wisdom” can be used for decision making (I recommend that this book be read along with The Myth of the Rational Voter and The Crowd to get a complete picture of where crowds are valuable and where they are very, very dangerous).

For a crowd to be “wise,” the participants must be independent of one another. Of all the tenets of Modern Portfolio Theory and the Efficient Market Hypotheses, this might be the most important. It is also absolutely false.

Mr. Surowieki uses the example of a county fair in which a crowd of people are asked to estimate the weight of an ox. They do so by putting their estimate on a piece of paper and putting it in a fish bowl. A curious researcher later found that, while individual estimates were all over the place, the average of all of the estimates together was almost exactly the correct weight of the ox. Alas, financial markets do not function like this. Not even close.

Real market participants do not sit back, unaffected by outside events, and write their “estimate” of a stock’s value on their trading ticket. Warren Buffet might come close to this, but by and large, virtually all other investors watch what other buyers and sellers do and react to it. Investors are not passive observers; they also affect the market with their actions. They are what they attempt to observe. This creates a feedback loop; what George Soros calls “reflexivity.”

In any event, I’m quite happy to see the CFA Institute changing its attitude toward the efficiency and rationality of markets. The British poll mentioned above is one example. But in recent years, I’ve also seen the Institute’s literature move more and more away from the naive “markets know best” view. An increasing number of white papers in the Institute’s publications have discussed “deviations” from market efficiency due to behavioral anomalies.

Behavioral finance is also becoming a more integral part of the curriculum on which candidates are tested — a change that I applaud. The CFA candidates today are the analysts, traders, investors, and hedge fund managers of tomorrow. An understanding of the limitations of market efficiency will no doubt improve the profession and (we can hope) help prevent some of the excesses that led to the 2008 mortgage and banking meltdown.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy