Who’s Afraid of the Efficient Market Hypothesis?

All the ladies in Washington are scrambling to get out of town.

–Dylan, “Thunder on the Mountain”

Critics of the Efficient Market Hypothesis Need to State Their Case in Stronger Terms.

Efficient Market Hypothesis

Robert Shiller does not believe in the Efficient Market Hypothesis. He has been engaged in research that refutes it for decades now. His book Irrational Exuberance makes the most painstaking and detailed case for a non-efficient market that has ever been written. Given all that, the words that Shiller uses to describe his views on the Efficient Market Hypothesis are remarkably restrained.

Here’s Shiller:

“The efficient markets theory and the random walk hypothesis have been subjected to many tests using data on stock markets, in studies published in scholarly journals of finance and economics. Although the theory has been statistically rejected many times in these publications, by some interpretations it may nevertheless be described as approximately true. The literature on the evidence for this theory is well-developed and includes work of the highest quality. Therefore, whether or not we ultimately agree with it, we must at least take the efficient market theory seriously.”

Et tu, Robert? Approximately true? Is being “approximately true” anything like being “almost pregnant”?

The Efficient Market Hypothesis is either true or it is false. Those are the only options. There is no “approximately true.”

Say that you were building a bridge. My understanding is that the people who design bridges rely on some form of calculus or some such thing (insert bad memory flashes here!) to know what sorts of materials are needed and where stuff needs to fit together and all that sort of jizz-jazz. Say that the people designing bridges were all relying on an understanding of mathematics that was only “approximately true.” That would be bad, right? Real bad, right?

I do not like the idea of driving over bridges designed pursuant to calculations that are only “approximately true.” Nor do I like the idea of investing my money (or seeing other people invest their money) pursuant to an investing theory that is only “approximately true.”

Is it true or is it not? Does the theory stand up to scrutiny or does it not? It matters. Can we get some of the big minds in the investing field to devote some mental energy to this question and come up with an answer that either warns us away from further reliance on the efficient market hypothesis or that offers us reassurance that all really is well and that we are not likely going to lose big portions of our life savings in days to come? It is my strongly held view that middle-class investors have every right in the world to expect that answers of this nature will be forthcoming from those who present themselves as experts in this field.

Many “Experts” Appear Not To Be Clear in Their Own Minds As to Whether They Believe in the Efficient Market Hypothesis.

One of the most surreal moments that I have ever experienced on a discussion board (and I have several dozen exceedingly surreal ones in my file) was the moment in which William Bernstein (author of The Four Pillars of Investing) declared on the Vanguard Diehards board that he does not believe in the macro version of the efficient market hypothesis (the macro version says that the overall market price is always in some sense “right”). I see nothing odd in the comment itself; the comment is pure common sense. The surreal part was that the leaders of the board, who respect Bernstein greatly and who run vicious smear campaigns against posters who express doubts about the efficient market hypothesis, ignored the comment. I suppose that they were too embarrassed to run a vicious smear campaign against their hero. But why didn’t they acknowledge having long been wrong in waging the smear campaigns used against many others? Why didn’t they change their views in response to this important new information bit?

It’s not done. I have never known anyone who at one time was an advocate of the efficient market hypothesis say that he or she has seen the light and now acknowledges the error of his or her former ways. Why not? Shiller’s book is an extended argument against the hypothesis. The book was a widely praised bestseller. Did it not change anyone’s mind? If it did, did that person go public with acknowledgment of the change of heart? Can you tell me who that person is?
Shiller Investing
Books are supposed to change minds. That’s the point. Did Shiller fail? Has his book been found universally unpersuasive? If it is so terribly unpersuasive, why did so many people praise it and why did so many people buy it?

I don’t think that’s it. I think that many found the arguments put forward by Shiller to be compelling. My sense (that’s all it is) is that many have to a considerable extent lost confidence in the dominant investing model of today and yet are reluctant to publicly say so. I believe that many of today’s investing experts are afraid to acknowledge that they no longer believe in the efficient market hypothesis.

They know too much and they care too little.

The Efficient Market Hypothesis Changed the History of Investing.

I conclude that they care too little when I bring to mind thoughts of what all this suggests is likely to happen to middle-class investors in days to come.

The efficient market hypothesis changed the history of investing. For many years, middle-class investors evidenced a healthy appreciation of the risks of stock investing, especially at times of high prices. The new theory says that prices do not matter, that there is no need to be concerned that valuations have recently gone to the highest levels ever recorded in the history of the U.S. market. If the theory is wrong, millions of us are doing 90 on a slick road surface without knowing it.

We have come to believe that we are investing prudently, but from the standpoint of the investing wisdom that prevailed prior to the rise in popularity of the extraordinary “Don’t Worry, Be Happy” investing mindset of the early 1980s forward, we are not. The efficient market hypothesis had better stand up to scrutiny. If it does not, a whole big bunch of us are well-positioned to experience a financial wipeout in the not too distant future.

How big a wipeout are we talking about? Here’s Shiller again: “If over some interval in the first decade or so of the twenty-first century the U.S. stock market is going to follow an uneven course down, as well it might — back, let us say, to its levels in the mid-1990s or even lower — then individuals, foundations, college endowments, and other beneficiaries of the market are going to find themselves poorer, in the aggregate by the trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country.”

Oh, good. At least there’s nothing to be alarmed about then.

Shiller doesn’t believe in it. Bernstein doesn’t believe in it. Robert Arnott doesn’t believe in it. Andrew Smithers doesn’t believe in it. Cliff Asness doesn’t believe in it. John Walter Russell doesn’t believe in it. David Dreman doesn’t believe in it. John Bogle has expressed serious doubts.

The theory has been around since the late 1960s. There has been plenty of time to check it out. If it passed the test, why is it that there are so many big names who are not convinced? If it failed the test, why is it that there are so many big names failing to warn us about the slow train coming up around the bend?

I’m thinking that maybe we should get a memo drafted and send copies to the millions of middle-class investors whose hopes for secure retirements are at stake. Is there anyone able to point to any possible downside?

Most Middle-Class Investors Do Not Know What the Efficient Market Hypothesis Is.

It’s not as if middle-class investors can figure this thing out for themselves.

Behavioral Finance Investing

The typical middle-class investor invests at least partly pursuant to the dictates of the efficient market hypothesis. The typical middle-class investor doesn’t know what the efficient market hypothesis is. What he knows is that most of the experts say that long-term timing doesn’t work and that prices don’t matter and that stocks are always best for the long run and that those who take on the risks of stock investing are sure to be compensated for doing so. These claims have been repeated so many times by so many people for so many years that the typical middle-class investor assumes there must be something to them.

If the efficient market theory fails, all of the ideas that follow from a belief in it fall too. Oh my!

The “experts” need to figure out what they believe. Then they need to report on what they come up with to the middle-class investors who have placed their trust in them. Yes, I really think that that’s the right and proper thing for them to do at this point in the proceedings.

The Appeal of the Efficient Market Hypothesis Is the Safety It Provides (Not for Investors, But for “Experts”).

I’ll share with you my take re what is going on. I don’t think that a lot of the “experts” spend a lot of time thinking through the theories that support the investing advice they offer. My sense is that what many are trying to do is to offer advice that is not wildly wrong, that is perceived as being reasonable, that will not get them in too much trouble. Advice developed pursuant to the efficient market theory fits the bill.

This stuff comes approved by tenured university professors. What could be more respectable? What could be more legitimate? What could be more safe? There’s a point at which a thing can become so safe that it’s dangerous. Anything perceived as so safe that it may never be questioned is dangerous.

The reality is that investing is a messy business. There really are pockets of efficiency in the market. There is a place for the numbers-based analyses that are done pursuant to the theory. The hypothesis properly reflects about half of what is involved in understanding how stocks really work. The half it ignores is the emotional side of the story. It is emotions that cause wildly overvalued markets like the one we are suffering through today (this article was posted in December 2007). The emotions stuff is harder to reduce to numbers than the non-emotional “efficient” stuff that is the sole concern of those who believe in the hypothesis.

Describe the investing project realistically and you need to make reference to fear and greed and envy and panic and anger and hate and all sorts of yucky junk. The sorts of people who aspire to become investing gurus generally would prefer to keep it to just the numbers, ma’am. They don’t like the uncertainty that comes into play when describing the effect that human emotions have on investing returns. Those who become believers in the efficient market hypothesis don’t have to! Today’s dominant model for explaining how investing works does away with all that with the wave of a magic wand. As Church Lady so often observes: “How convenient!”

Do they believe what they say? Kinda, sorta. My sense is that most don’t think about these sorts of questions hard enough to make it possible to say for sure whether they believe it or not. They say some things that suggest a strong belief in the theory and they say other things that suggest grave doubts. A good number do not seem to feel that it is imperative that they resolve the conflicts in their views. When I find myself in times of trouble, Mother Mary comes to me speaking words of wisdom: Let it be, let it be, let it be.

I’m with Paul Simon, who retorted: “I know they say ‘let it be,’ but it just don’t work out that way.” Let it be and we are likely to see millions of middle-class lives ruined. Could it be that Mother Mary really wants those of us who understand the flaws of this theory to let it be regardless of the consequences likely to follow? Yes, Mother Mary is forgiving. And Mother Mary is tolerant. And Mother Mary is gentle. All that is so. The other side of the story is that Mother Mary is honest. And Mother Mary is prudent. And she is kind. And she is smart.

Shiller on InvestingIt’s easier for the “experts” not to do the intellectual battle required to come to a firm conclusion one way or the other. The ones who suffer most from their failure to do so are the middle-class investors left holding the bill for the fire damage. That’s why God made middle-class workers, isn’t it? They’re the one who pay the bills when the goofy grandiose schemes concocted by their betters go wrong. Have you ever noticed that that is often the way it works out?

I’d like to hear some clearer statements. You’ve probably noticed that I have made it a practice in recent months to frequently put the word “experts” in quotes. I question whether people who cannot say in clear and direct and simple and unambiguous language what they believe about the dominant investing model of the day are truly “experts.” They haven’t earned the title. I don’t think I have earned the title either, for other reasons. I do feel obliged to at least try to answer the most important questions, however. I make an effort to address myself to the basics without fear or favor.

You don’t want to wait until prices have fallen hard to begin demanding clear answers to hard questions. If you feel any worries about the sorts of things I am making reference to in this article, now is the time to be making your voice heard.

It’s Going to Take Strong Language to Bring Down the Efficient Market Hypothesis.

I don’t think there is much to the theory. I think the efficient market hypothesis is going to fall of its own weight once the secular bear market that we appear to have entered in the year 2000 quits putting forward dark forebodings and gets serious about its job of stripping us of our bull market illusions. The efficient market hypothesis has never been tested in a secular bear market. Just about everybody who believes in it believes because of things they saw happen in a wild bull market and will stop believing when their reason for believing goes “poof!”

We won’t all stop believing at the same time. Those who stop believing first stop believing best. Those who continue believing longest pay the highest price for doing so. We’ve all had the injunction “Buy-and-Hold” drilled into our brains since the early days of the wild bull. It may be that we are going to need to learn a new catch phrase. Think-and-Protect?

It is the role of the investing expert to warn us about this sort of thing. That’s the job.

It doesn’t work for the experts to only begin to express doubts after prices have fallen a good bit. Humans don’t change their fundamental beliefs in a day or a week or a month. If the experts have doubts, they need to be giving voice to them today.

They need to be expressing their doubts in strong language. Shiller says that: “We must at least take the efficient market theory seriously.” I don’t agree. My inclination is to ridicule it.

Not to be mean. Not to be rude. Not to be difficult. There’s a place for ridicule. Ridicule is properly directed at ridiculous things. I see the efficient market hypothesis as a ridiculous thing.

And a dangerous thing. The Myers-Briggs personality assessment tool characterizes me (I’m an INFJ) as a “Protector.” Protectors protect. When we see our friends in trouble, we speak up, even if we are by nature a bit on the shy side. We force ourselves to step forward and have our say because we care about what happens to our friends. When we see our friends being hurt because people they depend on for the straight story lack the courage to provide it, we get steamed. The steam shows in the language we use. We ridicule ridiculous things.

There are lines that need to be drawn. I certainly do not favor personal nastiness of any sort. It’s one thing to ridicule an investing theory that has become far too big for its britches. It’s something else to start throwing stones at humans doing the best they can to make sense of this stuff under difficult circumstances. You’ve heard me taking shots at the Ivory Tower Eggheads. When it’s a particular Ivory Tower Egghead under discussion, I make it a point to observe that the fellow (it’s always a guy, isn’t it?) is a plenty smart individual. I believe that that’s the right thing to do. It’s not easy getting a gig as an Ivory Tower Egghead nowadays. Ivory Tower Eggheads work hard for the money. Still, my heart is with the middle-class investors. My general rule is to ridicule the idea, but not the people who advocate it.

People won’t stop believing in the idea until the idea is widely ridiculed. That’s what it takes to break through all the noise of the marketing campaigns in support of the efficient market hypothesis. There is no “there” there for the efficient market hypothesis. It’s silly. That’s my true take. Should I not put forward my true take?

What Happened to Stocks?

Not many do. Many of those who hold more realistic views on investing than those held by adherents of the efficient market hypothesis are careful not to step on toes, not to cross lines, not to offend, not to play their records too loud. This worries me. The one thing that I consider “serious” about the efficient market hypothesis is that it stands a serious chance of doing some serious harm to a serious number of good people. It’s seriously scary and those of us who see through it should be using some serious words to make some serious fun of it.

I sympathize with the desire not to offend; when I want to hear the Clash at full power, I put on headphones. But being quiet and thereby causing people to lose money is more offensive than letting people know that an investing idea that they have bought into is not all that it is cracked up to be. Those of us who see the holes in this theory find ourselves in circumstances in which we are required to offend one way or the other. I would far prefer to see my friends struggle with the pain of hearing some strong words about the weaknesses of their investing ideas than to struggle with the loss of a large portion of their life savings. If it takes being a bit “offensive” to get the word out about this silly and dangerous theory, I see it as an act of charity to put forward a few “offensive” words from time to time until the worst of the trouble has passed.

To Appreciate the Horror of the Efficient Market Hypothesis, You Need to Visit Investing Discussion Boards.

I didn’t become an investing “expert” by reading books or by taking courses or by managing big funds. Whatever expertise I can be said to possess I possess by virtue of the work I did during The Great Safe Withdrawal Rate Debate. I played the lead role in the most significant series of investing discussions in the history of Planet Internet and I learned some frightening stuff while doing so.

A good number of today’s stock investors are in pain. They are aware of the weaknesses of their investing beliefs. They do not want to face the problem. They want to avoid the problem. They hate the idea of being forced to deal with the problem. They are inclined to strike out in anger at anyone who confronts them with the realities.

That’s not good. Things are in a very, very, very, very bad way. It’s the fault of the efficient market hypothesis. This “theory” is an anti-thinking theory. If the market price really were always right, there would be no point in learning anything about how to invest effectively. By denying the effect of emotions on investing results, the hypothesis made investing a far less rational and thereby a far more emotional endeavor than it has ever been before. Until we put this theory to its final rest, stock investing will remain a dangerous, dangerous business for the middle-class investor.

I’ve seen reasonable people try halfway measures. I’ve seen posters who understand the weaknesses of the theory but who very much do not want to offend seek to criticize it gingerly, in a way that doesn’t stir up the anger of the theory’s defensive defenders. It never works. It never works. It never works. It never works. Those with the biggest emotional investment in the theory are too frightened to go along with halfway measures. They need to be told they are wrong. They need to come to terms with that reality before they can get themselves moving in the right direction again.

Efficient Market Debunked That’s it. That’s the magic. They need to be told they are wrong. Once they accept that they are wrong, the healing process begins. It can never begin so long as the rationalizations continue. Rationalization is the sickness and it is going to take some strong medicine to set things right after so many years of us hearing experts encourage the illusions that come natural to us as the consequence of our fallen nature.

The experts need to come down from their ivory towers, visit a few boards, and learn how real live people have come to make use of the efficient market hypothesis. The people are in a jam. The theory put them there.

If it’s only approximately right, it’s perfectly wrong. We need to take this one down.


When you believe in things you don’t understand,
You suffer.

–Stevie Wonder, “Superstition”