Suppose I told you that there's a leading academic theory
that is so self-evidently wrong that even my 9-year-old son,
when it was explained to him the first time, said, "But
that's stupid," and presented several solid objections.
And after decades of research debunking the theory -- so
much research, in fact, that a whole new academic discipline
rose up around it -- we still hear arguments for the theory
from people who should know better.
We even still hear people arguing that the theory's
originator should win the Nobel Prize for his efforts.
What's the theory?
Markets are rational. Put another way:
You can't beat the market.
Rational markets? Seriously?
Properly speaking, the theory is called the Efficient
Market Hypothesis, and what it says is essentially this:
Financial markets are "informationally efficient," meaning
that prices on traded assets already reflect all known
information, and instantly change to reflect new
information.
It certainly seems reasonable to say that; most of the
time, most stock prices move -- pretty much instantly -- in
response to news.
But "most of the time" and "most stocks" aren't enough to
justify what the theory's proponents famously argue: That
it's impossible to consistently outperform the market, unless
luck (or insider trading) is working in your favor.
So Warren Buffett, Peter Lynch, and countless Fools, all
of whom outperform the major market indices year in and year
out, are just "lucky"?
You know what I'm going to say: Not so much.
The little detail the ivory-tower crowd
missed
I could spend pages and pages going through all of the
problems with the efficient-markets idea. As I said above, a
whole new academic discipline -- behavioral finance -- has
grown up around research into the problems with the theory.
Simply put, behavioral finance is the study of how people
actually make decisions involving money.
Long story short, a lot of those decisions
aren't rational.
It turns out we're hard-wired to buy high and sell low. We
get attached to our first impressions and give too much
weight to evidence that seems to confirm them. We get carried
away by others' opinions in a sort of "herd mentality." We
value some dollars
more than others-- hard-earned dollars over "found
money," for example. We fear losses much more than we crave
gains, and we have a compelling need to believe that lost
money -- "
sunk cost" --
counts for something.
In other words, the little detail that the theory missed
is human nature.
Building a superior brain
These tendencies can be overcome, of course, with
education and practice. That's a big part of what we try to
do at the Fool. But these tendencies of human nature are what
drive clearly irrational market phenomena like bubbles and
crashes and stocks running wild on rumors, or sometimes on
nothing at all.
Some hard-core theorists would say that in a world of
perfect information, bubbles and crashes would occur only
when rational ideas justify them. But it sure didn't look
like a rational event during the first few days of March,
when the stocks below -- and
hundredsof others like them -- hit 52-week lows:
Stock
March low
Recent price^
General Electric (NYSE: GE)
5.87
14.47
American Express (NYSE: AXP)
9.71
35.68
Cisco Systems (Nasdaq: CSCO)
13.61
23.00
Las Vegas Sands (NYSE: LVS)
1.38 Continued... |