The Irrationality of the Efficient Market Hypothesis

“I’d be a bum on the street with a tin cup if the markets were always efficient. - Warren Buffett

“It is hard for me to see how anyone can consider the stock market efficient.” - Phil Fisher

“Value investors know – although efficient market believers fail to comprehend – that the underlying value of a security is distinguishable from its daily market price, which is set by the whim of buyers and sellers, as are the prices of rare art and other collectibles.” - Seth Klarman

"One of the worst examples of what physics envy did to economics was cause adaptation and hard-form efficient market theory. And then when you logically derived consequences from this wrong theory, you would get conclusions such as: it can never be correct for any corporation to buy its own stock. Because the price by definition is totally efficient, there could never be any advantage. And they taught this theory to some partner at McKinsey when he was at some school of business that had adopted this crazy line of reasoning from economics, and the partner became a paid consultant for the Washington Post. And Washington Post stock was selling at a fifth of what an orangutan could figure was the plain value per share by just counting up the values and dividing. But he so believed what he’d been taught in graduate school that he told the Washington Post they shouldn’t buy their own stock. Well, fortunately, they put Warren Buffett on the Board, and he convinced them to buy back more than half of the outstanding stock, which enriched the remaining shareholders by much more than a billion dollars. So, there was at least one instance of a place that quickly killed a wrong academic theory." - Charlie Munger

Unlike many fields of study, finance isn't a hard science. Most theories cannot be tested in a laboratory and quickly falsified. Finance has done a great job of explaining the inner-workings of corporations through mathematically verifiable equations, but I believe finance has led many students astray with its attempt to explain financial markets in the same manner. Financial markets involve significant estimates of the future in determining the valuation of assets, and for many reasons that I have previously discussed, such valuations may not reflect economic reality.

In summary, investors are highly emotional, have differing goals, have differing opinions, have differing time horizons, are significantly loss-averse, can become greedy, and of course- the future is difficult to predict. For these reasons, I believe that at nearly all times, valuations of financial assets will be inaccurate- the only question is how inaccurate. If they are within the range of reasonable values, we can say the security trades 'at fair value'- of course every now and then securities can be unreasonably priced. As Benjamin Graham noted, in most cases we cannot say with certainty the age or weight of a person. We can however, notice if they are young/old or underweight/overweight. Similarly, the value investor looks for situations where the security is significantly mispriced, even if the exact value cannot be determined with specificity. As long as the range of potential fair values isn't too wide, profitable investments can be made if we are certain the security trades far outside of that range.

To discuss the theory of market efficiency, I would rather not nit-pick every detail, but rather focus on the few big concepts which I believe to be rather absurd and which, as Charlie Munger would say, "violate mental decency". The theory of market efficiency dominates financial theory and is taught to business students worldwide as common knowledge, so it is both highly distressing and highly beneficial to value-investors that it has been so easily adopted as mainstream thought.

The main issue is the concept of risk. Simply, risk is the probability of a permanent loss. In its attempt to create a mathematically sound theory however, theorists have accepted the idea that risk is volatility. Risk, according to this framework, is how much one's financial assets change in price. A formula (CAPM) has been developed to help predict future returns based on this idea of risk being volatility, but what's important to note is that beta (β) represents the volatility of a stock relative to the general market. This equation of course, based on the idea that risk and returns are positively correlated- the higher the risk, the higher the returns. So, if a stock price moves more than that of the general market does, it is deemed to be riskier than the market and would be expected to deliver higher returns. Now that is a very smooth mathematical theory, as it allows one a nice equation on which to base returns and risk. The problem is that it defies logic. Along with the definition of risk being inaccurately defined, the idea that risk and returns are correlated is false, for reasons I will explain below.

A stock is a share of the ownership of a business. The stock price is the price one would have to pay for that share of ownership. If the stock price changes, it simply means that investors have changed their minds on the price of that ownership based on their trading action. Price changes can be completely coincidental- if an owner sells a large piece of that company, the price of the stock would drop. Do we believe that the value of the business has changed because that owner sold shares? Do we believe the company and its stock is riskier now after that trade occurred? What if people sell their shares out of fear and the stock price drops significantly, or if they become greedy and the stock price rises significantly in a short period- is the stock/business any riskier than it was a short while ago? 

The risk of any stock or business is the chance that one pays too much to become an owner. Only then can one experience a loss. All other price changes are temporary and simply a result of flippant changes in demand versus supply of the stock. 

Further, we can create a simple thought experiment to expound on this. Let's say that I purchase stock of company A which is certain to experience permanently but very slowly declining earnings and as a result the stock decreases by $1 a year, starting at a price of $100. In year 1, the stock trades at $100, in year two it trades at $99, and so on. Investors will experience permanent loss as the stock price and the company's earnings slowly deteriorate and never recover. 

Another stock of company B has rapidly growing earnings. It is tough to determine the exact future growth of earnings, so the stock price experiences swings over time, but as the company does well so does the stock. The stock starts at $100, increases to $140 in year 2, decreases to $120 in year 3, increases to $180 in year 4, and so on- ever upward.

Could any reasonable person say that the stock of company B is riskier than that of company A? Financial theory would say that since volatility is higher in company B, company A's stock is less risky. Such a statement defies reasonable borders of logic and small children could explain why that idea is flawed. Investors in company A will permanently lose wealth, and those in company B will do well over time. Volatility is of no help in determining the risk of these investments. There is an 100% chance of loss by investing in company A, but since its volatility is lower, it would have been deemed to be safer.

Another quick example. In 1999, stocks crashed. The stock prices of many large tech companies dropped 70%+. Now because of that price change and volatility, those stocks would have been deemed riskier after the drop than they were before it at higher prices. Would you rather purchase a company at $1 million or $300,000, all else being equal? Clearly the cheaper the company, the better the investor will do. Somehow, financial theory would indicate that paying a higher price is safer.

You could take this logic to its extremes. Say Apple Inc.'s market cap (the price of the entire firm) is $800 billion. If it were to drop to $100 tomorrow, would you say that it is riskier now? Somehow, financial theory would say that purchasing Apple at a grand total of $100 after that price drop would be riskier than purchasing it for $800 billion. I'll take Apple for $100. The CAPM formula posits that returns of a stock can be determined by its beta and volatility. I cannot be clearer that this idea fails basic tests of logic.

What's the risk of purchasing Apple at $100 after that massive price drop? I would say it is limited, because it has current annual earnings of $45 billion +. Purchasing a company which earns over $45 billion a year for only $100 doesn't sound risky whatsoever to me. As for the returns of this hypothetical investment? They are astounding. I would pay $100 and own a company earning over $45 billion a year. Thus, as the price to purchase Apple decreases, the risk to an investor decreases, and the returns increase. This is the case for any investment- the lower the price you pay for a company, the higher your returns. Risk and returns are negatively correlated for investors- aka as one increases, the other decreases.

If we define risk as the chance of loss, by purchasing a company at a low price we have minimized potential risk and maximized our potential returns. All the good investors of the past have understood this idea. As the stock price drops, the margin of safety between the purchase price and fair value of the business widen, and as that safety increases, so do returns as the investor buys earnings at a lower price. In our example here, as Apple drops from a market cap of $800 billion down to $500 billion, then $300 billion, then $500 million, then $1 million, then $100, the risk decreases and returns to the investor increase. Not complicated, but for whatever reason this is never explained in mainstream financial discussions.

If you are currently contending that changes in stock prices wouldn't happen without changes in real business value- I would firstly ask you to read my prior posts, and secondly I couldn't disagree more. There was a good piece put up by John Huber at BaseHitInvesting about fluctuations over the past year in the 10 largest companies in the U.S. based on market cap. These have the most analyst coverage, with very stable businesses and solid results. The swings in just a year range up to 72%. If you look at the stock charts, they fluctuate wildly up and down over time but have stable and promising results. Do we really believe that the value of Johnson & Johnson, an 131 year old company with incredibly stable and slowly growing earnings that sells basic consumer products such as diapers and baby powder has swung by over 40% in just a year? Clearly not. The swings in price are even more drastic for lesser-known firms and in my experience usually have nothing to do with changes in business value.

Apple has been a great investment over time because it has produced highly popular and profitable products that other firms are unable to replicate and as a result, has grown earnings at high rates over the past decade. The changes in its stock price based on temporary swings in supply and demand are of no matter to its returns to investors in the long-run.

All firms which compound earnings and net worth have stock charts which look like the one below of Starbucks- exponentially upwards. Note the Dow Jones Index below in red, which has been handily defeated over the entire public history of the company. Do we believe that Starbucks has done so well compared to the Dow because the stock is somehow riskier and more volatile? Or do we think it is because of its ability to compound earnings as the firm grew over time? It shouldn't be a difficult question to answer. Also note that the beta of Starbucks is 0.81- a beta under 1 indicates that the stock is less volatile than the market, above 1 indicates it is more volatile. Somehow its beta is lower than that of the market and therefore less volatile and yet it has handily beat the market over basically any period of time you can think of (1 year, 5 years, 10 years, 10+ years, etc). Once again, it seems clear what the answer is.



Fama and French, two theorists who have been at the forefront of this market efficiency movement, have identified 'anomalies' to their theory. These anomalies include the fact that smaller firms on average deliver higher returns and that firms purchased at low price-to-book values on average deliver higher returns. This has caused much debate as to why this is the case in academic circles, but it should be clear to us as investors and business-people why this is the case. Small companies tend to grow earnings faster, and therefore grow their market capitalizations/ intrinsic values quicker. Similarly, if you purchase a company for less than its net-worth (book value), you are also more likely to do well. Other studies have shown that low P/E stocks on average beat the S&P 500 index- it should be clear why this is the case. On average, if you pay less for a company's earnings, you will have a higher rate of return. On a case-by-case basis P/E is merely a crude tool and not always indicative of true value, but regardless the reasoning should be simple to understand.

Buffett once said that you either understand that perfect market efficiency is irrational quite quickly, or not at all. If after reading all this I haven't convinced you, or at least shaken your faith in the theory of perfect market efficiency, then as Obi-Wan Kenobi once said- "You are truly lost".