From the 1988 Berkshire Hathaway (BRKa) Shareholder Letter. In that letter, Warren Buffett provides some thoughts on "efficient market theory" (EMT).
Amazingly, EMT was embraced
not only by academics, but by many investment professionals and
corporate managers as well. Observing correctly that the market
was frequently efficient, they went on to conclude incorrectly
that it was always efficient. The difference between these
propositions is night and day.
In my opinion, the continuous 63-year arbitrage experience
of Graham-Newman Corp. Buffett Partnership, and Berkshire
illustrates just how foolish EMT is. (There's plenty of other
evidence, also.) While at Graham-Newman, I made a study of its
earnings from arbitrage during the entire 1926-1956 lifespan of
the company. Unleveraged returns averaged 20% per year.
Starting in 1956, I applied Ben Graham's arbitrage principles,
first at Buffett Partnership and then Berkshire. Though I've not
made an exact calculation, I have done enough work to know that
the 1956-1988 returns averaged well over 20%. (Of course, I
operated in an environment far more favorable than Ben's; he had
1929-1932 to contend with.)
All of the conditions are present that are required for a
fair test of portfolio performance: (1) the three organizations
traded hundreds of different securities while building this 63-
year record; (2) the results are not skewed by a few fortunate
experiences; (3) we did not have to dig for obscure facts or
develop keen insights about products or managements - we simply
acted on highly-publicized events; and (4) our arbitrage
positions were a clearly identified universe - they have not been
selected by hindsight.
Over the 63 years, the general market delivered just under a
10% annual return, including dividends. That means $1,000 would
have grown to $405,000 if all income had been reinvested. A 20%
rate of return, however, would have produced $97 million. That
strikes us as a statistically-significant differential that
might, conceivably, arouse one's curiosity.
Yet proponents of the theory have never seemed interested in
discordant evidence of this type. True, they don’t talk quite as
much about their theory today as they used to. But no one, to my
knowledge, has ever said he was wrong, no matter how many
thousands of students he has sent forth misinstructed. EMT,
moreover, continues to be an integral part of the investment
curriculum at major business schools. Apparently, a reluctance
to recant, and thereby to demystify the priesthood, is not
limited to theologians.
Naturally the disservice done students and gullible
investment professionals who have swallowed EMT has been an
extraordinary service to us and other followers of Graham. In
any sort of a contest - financial, mental, or physical - it's an
enormous advantage to have opponents who have been taught that
it's useless to even try. From a selfish point of view,
Grahamites should probably endow chairs to ensure the perpetual
teaching of EMT.
Remarkably, you'll find EMT taught to this day at respected universities and colleges.
I've said before that it's best to never underestimate how long it takes for lousy yet influential ideas, even if they happened to be cloaked in respectability, to disappear.
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