This major new creed has pervaded our academic institutions for three decades. Today, it affects almost every aspect of Wall Street thinking from the proper makeup of your retirement funds, to how to select an investment advisor. It also plays an important role in the decisionmaking of many large 11 8, and influences the SEC and govemment pohcymakers. The hypothesis has been so widely accepted in academic circles and on Wall Street that several of its leading proponents-Franco Modighani, Harry Markowitz, William Sha e, Merton Miller, Myron Scholes-have received Nobel Prizes for their contributions.-

The new theory came at a time when there was little to oppose it. The old market methods were dying. None of the ancient rituals seemed to work, no matter how rigorously they were applied, or how extensive the training, experience, or intelligence of the practitioner.

Into this vacuum came the seductive idea of efficient markets, offering a plausible explanation of the professionals failure, absolving investors of blame (for it preached it was not in their power to change things). Order replaced chaos. Converts flocked to the new gospel by the milhons.

The spread of the new faith was not unlike the conquest of the vast Inca empire by Francisco Pizarro and his 180 conquistadors. Like the conquistadors, the scholars used both the faith and the sword to annihilate the pagans beliefs in the marketplace. If the tme faith was not accepted, why then there was the sword-the unleashing of volleys of awesome statistics disproving everything the professionals believed. The frightening new weapon of statistical analysis awed the Wall Street heathen more than Pizarros cavalry did the Incas, who had never before seen a horse. What amazes, in looking back, is that the leaders of the new faith subdued milhons of investors with a smaller troop than the original conquistadors.

But the golden age of efficient markets was not destined to last. Smash, boom, bang, along came the 1987 crash and the pillars of the new paradise cmmbled. In retrospect, the elegant hypothesis had a minor hitch. The professors assumed investors were as emotionless and as efficient as the computers they used to build their theory. The October 19, 1987, crash, 80% worse than 1929 in percentage terms and over a thousand times larger in actual dollars, showed it just wasnt so. Like a bizarre Rube Goldberg machine, the theoretically flawless trading systems the professors had introduced tumed into a monster unleashing massive panic. The market ended 508 points lower that day. In five trading days ending on October 19, the market had lost one-third of its value-about one trillion dollars.

When the New York Stock Exchange (NYSE) opened on the moming of October 20, the professors supposedly foolproof trading mechanisms sent stocks into another devastating free fall. To end the rout, the NYSE was forced to ban the new academic tools that were supposed to create Eden on Wall Street. The entire financial system came within a hairs breadth of disintegration, according to the Brady task force and SEC reports commissioned to study the crash. The worst crash in modem history was caused by a theory devoid of any understanding of investor psychology.

The academic dogma that investor psychology played absolutely no role in markets justified the new trading mechanisms responsible for the debacle. This was not something to be faulted only with 20/20 hindsight. Numerous market observers wamed of the impending calamity. Eighteen months before the crash, the new academic trading strategies caused Representative John Dingle of Michigan, then-chairman of the House of Representatives Committee on Energy and Commerce, which oversees the SEC, to fear a panic. John Phelan, then-president of the New York Stock Exchange, had also wamed that the interaction of the new academic programs could cause a market meltdown. "When I first started talking about this in late 1986," Phelan was quoted as saying after the crash, "people would do almost anything but physically attack you."9

I was also worried about the dangers inherent in the academic trading systems. Writing about them in a Forbes column six months before the crash, I noted that the enormous volume in computerized trading programs, portfolio insurance, and numbers of other such strategies all based on financial index futures at low margins, amounted to a potential doomsday machine." The column concluded that if uncontrolled, these aberrations set up the possibility of a sha correction, if not a crash, not far down the road.

Even though the most destructive of the low-margined trading systems created by efficient market believers were all but completely dismantled in the next several years, the academics who sponsored them, like the faithful of other disproved scientific theories, hung on tenaciously. Everything was blamed but the actual reasons as determined by the commissions set up to study the causes of the crash. To do otherwise would be no less than admitting that the theory was as useful as the eighteenth-century medical belief that bleeding the patient balanced the bodys humors.

No, the revolutionary new ideas that sprouted from ivory towers across the country wont give you the odds Ive discussed earlier, or for that matter even keep you afloat. But though the theory began to disin-

A Titanic Clash

We find ourselves in the midst of a sea change of thinking in the investment world, one whose ramifications extend far beyond the stock market, and even beyond economics. Scientists call such changes paradigm shifts. A paradigm encompasses the working behefs underlying all theory and research in a particular science. Paradigms shift rarely, and the shifts are always resisted by the creators of the old system of beliefs. Bitter polemics and enormous rancor are usually spilled before the change prevails. Still, it is within this paradigm shift that we will find the key to the winning odds in the marketplace.

It is never easy to give up your most basic beliefs. As we all know from our school days, the Ptolemaic system, which held that the earth was the center of the universe, resisted change for centuries. With improved telescopes and more accurate observation, sighting after sighting over the years found planets where the theory stated they shouldnt be. The model became increasingly complex in order to 1 1 each new piece of information. The planets and stars moved around the earth in a combination of circles, epicycles, and deferents (points moving on large circles around which the epicycles simultaneously revolved). The result of this hodgepodge was a mind-boggling whirl.

Still, it took generations for scientists to accept the radically different heUocentric paradigm of planetary motion. As Paul Samuelson once phrased it, "Scientific progress advances funeral by funeral."

Markets whirl along in a similar state today. Each new statistical finding throws the efficient market hypothesis into further disarray and requires additional explanations for the sighring of "anomahes" ruled impossible by the theory.

That said, this book is not a scientific treatise. But it is important for the reader to have some understanding of the intellectual clashes in investments and economics today, because the winning odds we will ex-

tegrate with the crash, it left an enormous void among investors. Many of the basic teachings of the efficient market hypothesis (EMH) have now have been conclusively refuted by advanced forms of the same statistical analysis that devastated the investment heathen. Yet contemporary investment practice is built around the behef in efficient markets. Large numbers of investors, though they believe the theory bankrupt, dont know where else to tum.

Where then do the odds of market success lie? Or are there any real odds at all?