Woody Allan’s Take on the Efficient Market Theory

“If I listen long enough to you,
I’ll find a way to believe that it’s all true.

–Tim Hardin, ”Reason to Believe”

Woody Allen tells a joke with relevance to today’s stock investor (this article was posted in March 2007) in the movie Annie Hall. It seems that there is a fellow who complains to a psychiatrist that his brother thinks he’s a chicken. The shrink asks the fellow why he doesn’t turn him in. The fellow explains that: “I would, but, you see, doctor — I need the eggs.”

Woody says that relationships are like that. They’re often a crazy and mixed-up business. But we keep at them because “most of us, we need the eggs.”

Woody Allan's Take on the Efficient Market Theory
I say investing is like that. The Efficient Market Theory is today’s dominant model for how investing works. It says that investing is a rational endeavor and that thus the market price always comes close to being the right price. No investor should try to outguess the market by lowering or increasing his stock allocation in response to price moves, according to this theory, because there is just no way to form a better idea of the right price for stocks than that old efficient market.

This is a dangerous sort of silliness, of course. The first great truth about stock investing is that the market price is always wildly wrong in one direction or the other or at least on its way to becoming wildly wrong. Investors get wildly over-enthusiastic over stocks, push prices up to absurd levels, suffer big losses, and then get wildly under-enthusiastic over stocks just when prices become highly appealing. We need to junk the Efficient Market Theory and replace it with something that better explains the investing realities as they exist here on good old Planet Earth. Are you ready for the rise of the Emotional Market Theory?

Not all of us are entirely prepared to take that step in the direction of rationality (yes, it’s more rational to acknowledge that we have emotions than to practice denial on this point) just yet. Not to worry. You don’t have to stop believing in the Efficient Market Theory just because you know it’s not true. This article offers a handy-dandy list of twenty-four of the more popular rationalizations used by those seeking a reason to believe for just a wee bit longer.

Rationalization #1 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Lots of Experts Haven’t Entirely Given Up on It Yet.

Perhaps they don’t express their belief with as much conviction as they did back in the Summer of 1999. But few experts have come out and said flatly that they do not believe in the Efficient Market theory. That’s something.

Rationalization #2 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — The Experts Who Have Given Up on It Don’t Make Much of a Fuss About It.

Some experts have given up, of course. There recently was a discussion at the Vanguard Diehards board at which William Bernstein said that he believes only in the micro version and not the macro version of the Efficient Market Theory. The macro version is the one that counts for the purist indexers who congregate there because it is their belief in a macro-efficient market that causes them to believe that they should not change their stock allocations in response to wild price swings. So that was potentially a bombshell admission. Not to worry, though. The entire board community just pretended that Bernstein never said it, and life went on as usual. I don’t get the feeling that Bernstein is preparing an article exploring the implications of his belief that the market is not macro-efficient. So long as we all pretend that he never said what he said, it doesn’t really make much difference that he said it, does it?

Rationalization #3 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Most of Your Friends and Neighbors and Co-Workers Believe In It.

Can 600,000 Elvis fans all be wrong? No way. Neither can the millions who continue to believe in the Efficient Market Theory despite it all. Don’t worry, be happy.

Rationalization #4 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Theories Don’t Matter Anyway.

Say that there’s not a grain of truth to the Efficient Market Theory. It’s just a theory anyway, right? Stock prices haven’t come down yet. So everything’s cool.

Rationalization #5 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Believers Are Ahead of Their Time.

Investing theories discredited

A belief that the market price is the best price is a belief that comes into and out of fashion, depending on how high stock prices have gone. We’ve seen this theory become popular before and we will see it become popular again. It may be that as prices come down there will be fewer and fewer investors willing to say a kind word on behalf of the theory. But prices will go up again someday, and the theory will be king once again. There is no reason why those refusing to give up their belief in the theory need to think of themselves as a little behind the times. They just as properly can think of themselves as a good bit ahead of the times.

Rationalization #6 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — It Makes It Easier to Understand How Stock Investing Works.

Most of today’s investing literature is rooted in an assumption that the Efficient Market Theory is true. Most of the existing articles are a pain to work your way through now. Can you imagine how much worse it is going to be if you acknowledge that the Efficient Market Theory is bonkersville and so even the parts that now seem to make some sense no longer do? Do we really need to open this can of worms?

Rationalization #7 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Updating Investment Strategies Is a Lot of Work.

It’s not just the articles in the investing literature that become out of date once you throw the Efficient Market Theory into the trashbin of history. That move renders the investing strategies rooted in a belief in the theory out of date too. Hello? Do you enjoy reformulating your investing plan? If not, perhaps you had better let sleeping dogs lie and pretend you never heard any of those arguments for why the Efficient Market Theory does not add up.

Rationalization #8 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Acknowledging the Realities Could Give Rise to Transaction Costs.

If you change your stock allocation to something more realistic, you will incur transaction costs. Ignore the flaws in the Efficient Market Theory, and you avoid these costs. It’s found money! The proverbial free lunch!

Rationalization #9 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — You Might Mess Up Anyway.

Say that you abandon the good old Efficient Market Theory and replace it with some more realistic investing model. Does it follow that you will obtain good results with your investing choices from that day forward? It does not. Anyone can mess up, even those smartypants types who abandon the Efficient Market Theory on the 101st sign that it doesn’t work. Sheesh! At least those messing up because they stuck with the Efficient Market Theory will be able to say that they didn’t expend any additional effort in the cause of messing up, that the mess-up just sort of crept up on them naturally.

Rationalization #10 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Believing Hasn’t Hurt Us Much So Far.

Investing Confused

U.S. Stocks have not performed as they are “supposed” to for seven years now. But they haven’t done so terrible as of yet either. Is there some reason why we need to abandon the Efficient Market Theory now, before we even experience a price crash? Where’s the fire?

Rationalization #11 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Stocks Might Perform Differently in the Future Than They Have in the Past.

The biggest argument against the Efficient Market Theory is that stocks have never in the past performed in the way in which this theory says they are supposed to perform. I can understand why some folks see that as a problem. Still, there’s no guarantee that stocks will perform in the future as they have in the past. Isn’t it possible that stocks could today begin performing as the Efficient Market Theory says they are supposed to perform? Stranger things have happened.

Rationalization #12 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Stock Prices Could Go Up Sharply in the Short Term.

Even those who point out the flaws of the Efficient Market Theory acknowledge that stocks can go up in the short term, no matter how high prices are today. Do you really want to miss out on all the exciting action? Did I not hear you observe one day not too long ago that “baby needs a new pair of shoes!” Think it over.

Rationalization #13 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — It Would Require Admitting That You Were Wrong at An Earlier Time.

Admitting that you were wrong about something is a bummer. Tell me I’m wrong about that one! I mean, don’t tell me!

Rationalization #14 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Short-Term Timing Doesn’t Work.

If the Efficient Market Theory is not true, there is no reason not to engage in long-term timing. It would be crazy not to change stock allocations a bit in response to wild price swings if it is possible to know when prices are truly out of whack. Still, it’s easy to engage in word games that will serve to confuse yourself and others on this point. There is lots of evidence that short-term timing doesn’t work. Both the phrases “short-term timing” and “long-term timing” have the word “timing” in them. Do you appreciate the opportunities presented by this reality to keep yourself and others in a fog as to how investing really works for a long time to come?

Rationalization #15 for Continuing to Believe in the Efficient Market Theory Even After Learning That It’s Not True — You Can Always Change Your Mind Later.

After stock prices crash, there won’t be much point in sticking with the Efficient Market Theory. Fine. You can abandon your belief in the Efficient Market Theory then, along with lots of other folks. Must you be an early adopter? Haste makes waste.

Rationalization #16 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Even Retirees Might Survive the Effects of Believing in a Flawed Investing Theory.

One of the arguments against the Efficient Market Theory is that belief in it is going to cause a lot of busted retirements among retirees who put together their retirement plans without considering the effects of high valuations on the long-term survival of those plans. It of course makes the theory sound bad to point out the human suffering that is likely going to follow from a widespread belief in it, assuming that stocks perform in the future somewhat as they always have in the past. But the reality is that retirees have options. Couldn’t they tighten their belts and live on less? Must we all give up the comfort of our belief in the Efficient Market Theory out of concern for the effect that continued belief in it will have on a few million retirees? Is that not a bit of an overreaction?

Investing 101 Rationalization #17 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — New Theories Might Contain Flaws Too.

It’s taken us some time to learn about the flaws in the Efficient Market Theory. We don’t know about the flaws of the investing model that will replace it yet because we haven’t seen it in action yet. It’s really not fair to compare a theory that has been tested and that has failed with a theory that has not yet been tested. At least we know about the flaws of the existing theory. Who knows what sorts of flaws we will discover in years to come in whatever theory comes to replace it? Replacing the Efficient Market Theory is like replacing an old pair of sneakers just because they have holes in them. Who wants to give up those comfortable old sneakers?

Rationalization #18 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — There is Almost Certainly Some Truth to the Efficient Market Theory.

The Efficient Market Theory is not entirely wrong. There are indeed pockets of efficiency in the stock market. Must we be so persnickety as to demand that our investing models be accurate as stated?

Rationalization #19 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Giving Up on the Efficient Market Theory Might Complicate Investing.

One nice thing about the Efficient Market Theory is that those relying on it to understand investing don’t need to worry about all that icky emotional stuff. Include that stuff for the sake of accuracy and you are going to end up with a more complex investing model. Not good.

Rationalization #20 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — It’s More Important to be Rich than to Be Right.

Lots of people made a lot of money by believing in the Efficient Market Theory during the wild bull market. Those people are a lot richer today than the sorts of people urging us to move into sissy investments now that prices are so high. Need I say more?

Rationalization #21 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — It’s Better to be Lucky than to be Smart.

Problems with conventional investing advice

There are some scenarios that people have imagined in which continuing to believe in the discredited theory might not hurt us so much. You never know.

Rationalization #22 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Those Who Have Been Investing Long Enough Will Likely End Up Ahead Anyway.

Those who have been buying stocks since the early 1980s are so far ahead at this time that they will likely remain ahead regardless of what happens as we return to reasonable prices. Why is it again that some say we need to replace the Efficient Market Theory?

Rationalization #23 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — If You Change Your Stock Allocation, You’re Just Going to Have to Change it Back Again Later.

Say that you abandon ship on the Efficient Market Theory and adjust your stock allocation to something more realistic for today’s price levels. You’re just going to have to adjust it back up again when prices fall. Who needs the botheration?

Rationalization #24 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Stop Believing, and You’ll Have to Acknowledge Your True Net Worth.

Efficient Market Theory Cons

The next step after acknowledging that today’s market prices are la-la land stuff is acknowledging that the value you now assign to your stock portfolio is la-la land stuff too. Let’s see, stocks are now priced at about double their fair-value price. That means that your stock portfolio is worth about…

…You don’t want to go there. Trust me on this one.

Explanatory Note: This article aims to make a serious point by employing a good number of goofy arguments. The idea here is not to have you see merit in any of the goofy arguments. The point is to see if we can get papers drawn up to turn that crazy brother of ours into the authorities. We don’t need the eggs that badly!

Do we?

 

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