Warren Buffett wrote the following about efficient markets in the 2010 Berkshire Hathaway (BRKa) shareholder letter:
"John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it 'anomalies.' (I always love explanations of that kind: The Flat Earth Society probably views a ship's circling of the globe as an annoying, but inconsequential, anomaly.)"
Well, they may have clung to the theory in the 1970s and 1980s, but it is 2013 now. Sometimes ideas -- and occasionally even the not very good ones -- have a funny way of being persistently influential.
In other words, it used to seem surprising that a plainly flawed theory would continue to be taken seriously over such a long period of time.
Not anymore.
I've come to almost expect it and suspect that certain institutional dynamics -- with an assist from some forms of psychological bias -- contribute greatly to this.
From the prior post:
...for lots of reasons, too many participants tend to underperform and that's likely to continue. There would seem to be little doubt about that considering the evidence. As I see it, here's the problem and where the disagreement begins:
When someone -- I think it is fair to say -- rightly points out how difficult it is to outperform the market over the long haul, it seems the default primary reason offered is often the inherent efficiency of markets.
At first glance seems reasonable enough yet that, I think, is not just somewhat incorrect but, more or less, a grossly wrong conclusion.
...and later in the same post:
The inevitable reality is that, in aggregate, market participants can only produce the market returns minus frictional costs. That doesn't mean it's not worthwhile to reduce the adverse effects, where possible, of the many behaviors that get market participants into trouble or otherwise hurt results; that doesn't mean it's not worthwhile to seek improved capabilities among market participants.
Participants do tend underperform but it's not due to the efficiency of markets. Some of it comes down to investment skill; some of it, temperamental and psychological factors. Our minds are susceptible to a variety of cognitive biases and emotional biases and other behavioral tendencies that can adversely impact results. The misjudgments that result from these biases can be mitigated (at least they can be to an extent via an appropriate trained or learned response), investment skills can be improved, but it all starts, of course, with understanding it's even worth trying to do so.
"...academics at prestigious business schools...were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value - and even thought, itself - were of no importance in investment activities." - Warren Buffett in the 1985 Berkshire Hathaway Shareholder Letter
Buffett: Indebted to Academics
Now, attempting to combat those things that tend to get investors into trouble hardly guarantees improved individual performance over the long haul. That's just the reality. Long run outperformance, with all risks considered, just isn't an easy thing to do. Yet, to me, it does seem likely that having a critical mass of market participants (or, at least, a meaningfully higher proportion than what we have now) more oriented toward (and skilled at) judging price versus value -- or, at least believing it was worth trying to do so -- might just reduce the number and degree of mispriced assets in capital markets. More emphasis by more participants on long-term effects with less betting on short-term noise and price action -- whether fundamentally or technically based -- certainly couldn't hurt. The same goes for participants being more aware of and learning to control, at least to an extent, the many psychological factors that do the most damage to results.
It might even make bubbles of various kinds at least somewhat less likely.
If so, it should also mean less frequently misallocated capital, reduced frictional costs (if there were fewer "stock-renters" and, instead, more long-term oriented stock ownership), and a system that serves the world a whole lot better than it currently does.
"...if you call investment fulfilling the basic function of the financial system, and that is directing capital to its highest and best uses, you're talking about money [that] gets directed in new ventures, existing companies, innovative companies, whatever it might be. And that has been running about $250 billion a year. How do you measure speculation? [You do so] by the amount of trading that goes on in the market, and that's around $33 trillion a year." - John Bogle in a Morningstar Interview
Though, with fewer mispricings, it seems likely that it would become more difficult for individuals to outperform. Not such a bad thing for the world, even if it makes life harder for individual market participants to outperform.
This seems hardly like a problem at all. If investors mostly made their returns from real increases to per share intrinsic business value, less from other factors, maybe some very talented people would focus their energy on something more useful than the frequent trading of marketable stocks and related activities.
Whether the holding period is measured in seconds, minutes, days, weeks, months or even a year less of that sort of thing would be progress.
I'm thinking many years from now we'll still have faithful adherents to the idea of efficient markets (and related modern financial theory) despite the available contradictory evidence.
Unfortunately, it's unlikely that their influence will be diminished anytime soon.
This isn't to argue -- and I mentioned this in the prior post -- in favor of buying individual stocks. It's rather just the opposite.
John Bogle thinks most investors would be better off consistently buying broad-based index funds over time. There is no shortage of evidence to support his sound advice. It's, in fact, pretty overwhelming. Yet, there'll still be no shortage of participants who continue to kid themselves that, over the long run, they can outperform by buying individual stocks over the long run.
Some can and will outperform long-term, of course, but it seems probable that too many who should be taking Bogle's advice will continue to ignore it.
Only after a very long measurement period -- along with, considering the risks, careful objective comparison of results to an appropriate benchmark -- will it become clear that bothering with individual stocks was worth the trouble.
That reality just doesn't logically lead to the conclusion that markets must be efficient.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
* This includes even those who happen to use fundamental analysis to try and do so. Some think that if fundamental analysis is being used it must be investment. Well, investment has as its focus what a productive asset will produce over very long time horizons. Speculation does not. It's focus is mostly on price action. There's nothing wrong with speculation but it has less in common with investment than some think (even if there's no clear cut line that separates the two activities and they sometimes overlap). There will always be room for speculation especially on the shares of businesses with inherently more unpredictable future outcomes. Some proven businesses have a rather narrow range of likely business value while others naturally do not. There are, of course, plenty of very capable, long-term oriented, market participants. I'm merely suggesting the markets would function at a higher level if there was a greater proportion of participants focused on effectively judging price versus value and long-term effects; a greater proportion acting like owners instead of renters. Basically, that equity markets would better serve their real purpose -- that is, making sure capital is effectively formed in sufficient scale and allocated to the best possible use -- if there was less short-termism. Equity markets are also, as John Kay says, better able to "sustain high performing companies" when they're functioning well. That means having investors who, by and large, are willing to think beyond the next quarter or two. With any system, even a comparably simple one, the proportion matters. I mean, it's not like a petrol engine functions all that well if the air-fuel ratio strays too far from optimal (and, eventually, it won't function at all if there's too much of either substance). If allocating capital well and high long run company performance are the primary goals then, in their current form, the equity markets seem likely to have far from the optimal ratio of speculation relative to investment.
** Even if, considering human nature, capital markets will likely always be unpredictable and volatile. That doesn't mean attempts to make it less so aren't worth the trouble. Some of this comes down to system design but a whole lot of it comes down to the market participants themselves. Human nature, as well as an inherently uncertain world, assures there is no such thing as a precisely knowable correct price. So the market will never provide perfect prices. Participants in the capital markets will always be susceptible to individual behavioral bias as well as herd behavior -- cognitive, emotional, and social psychological forces. Investing is messy even at it's best. In an always uncertain world, too many unknowns exist to be able to ever pin down the precise intrinsic value of an asset. Certain inherently speculative assets will always have the widest range of possible values and market price fluctuations. Value and price are two entirely different things. A dominant snack food company certainly has a much narrower range of outcomes than some tech startup. As a result, market prices will fluctuate more for the latter. That increase in price fluctuations does not necessarily imply increased returns as some modern financial theory might suggest.
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