Beyond Efficient Markets

HERE is a much quoted line from George Santayana you have likely heard. "Those who cannot remember the past are condemned to repeat it." (Although the world of finance seems chock full of good examples, Mr. Santayana was a philosopher, not an economist.) However, rarely, if ever, noted is what immediately precedes this famous one liner: "Progress, far from consisting in change, depends on re-tentiveness." Which suggests, to cast it in more specific terms, that your financial progress cannot be secured by embracing the fashion of the moment, whether it is a new stockbroker, a "hot" mutual fund, or the latest wrinkle in market theory. It is in remembering what works-and perhaps more important, what doesnt work-that guidance can be found and a strategy adopted that will serve you well over the long haul.

Much of this book has been a testament to such principles. Based on the historical record, we have examined the results of some of the traditional and current approaches to investing and found them wanting. In particular, we reviewed the development and ascendancy of a powerful new theory of markets, the efficient market hypothesis. Fittingly likened to a new religion, EMH has in the last three decades gained thousands upon thousands of converts, both in the academic institutions and among market professionals. Today, as we know, it affects every aspect of Wall Street thinking.

The theory brought order and structure where there had been chaos and bewilderment. Littie opposed the swift conversion. There was nothing better, nothing that could more rationally ravel out the workings ol financial markets. More and more investors, taught that fundamental and technical analysis were mere rehes of a pagan cull, came to scorn all the "old" ideas.

It has been quite a change as Santayana would dub it, but progress? In a word, no. For as we approached the issue from many possible points of analysis, again we found that the theory could not produce the results EMH claimed were logically, if not mathematically, a foregone conclusion. To start off this chapter, we will take a close look at where EMH and its close ally MPT (modem portfolio theory) stand now. What lies ahead will be startling to some, highly provocative to others. For after an almost unopposed sweep through the marketplace of ideas, and despite fending off every criticism of genuine merit or substance, EMH and MPT both continue to fail dramatically.

Even more significantly, these theoretical pillars have failed by the measure of what they held forth as their strength. The statistical methods, for which several leading researchers were awarded Nobel prizes in economics, tumed out to be valueless in the marketplace. Yet, even with the scientific unde innings demoUshed, the faithful believe and still cling to EMH dogma. For that is what I believe it has become. Ironically, the original apostles of the faith prevailed because of their insistence that it was empirical evidence that mattered, not the dogmas of another day and age of investing.

As we count down the days to 2000, several loud homs outside the walls of this modem investment Jericho seem appropriate. If I can leave you with some counterblasts firmly etched in your mind, it may just wind up saving you a bundle.

There are serious problems with EMH beyond what we found in chapters 3 and 14. Dogma, whether in inappropriate statistics or astrology, will not save you in the marketplace. Everyone is going to want to find a better way, sooner or later. Naturally, the "sooner" will be the investors who are most likely to profit and prosper.

A recapitulation of EMH and MPT is warranted for two reasons. First, its important to understand how much your investment portfolio depends on this theory. Second, it is necessary to see why these methods fail the reader, in order to be fully comfortable with the new contrarian strategies. There are no labels to wam you away from the EMH-MPT trap-lacking knowledge, you can easily be snared. A flawed theory is not market neutral; it can be destmctive to the capital of the average and the sophisticated reader ahke.

Understanding is essential to the contrarian approach, particularly during a market crisis, when the investment world seems to be collapsing. People who know what they are doing-and why-are usually the ones who seize the opportunities bobbing in the chaos. In crisis the "black box" investor usually throws away the box and mns.

MPT Assumptions Revisited

As we discovered, MPT and EMH are supposedly based on rigorous assumptions, but many of them are highly unrealistic, if not downright foolish. We see in Appendix A a sampling of the gap between the MPT assumptions and reality, and in chapter 14, a similar gap for risk.

But let us ask the hidden question: do we need realistic assumptions? Or is EMH, like Riemannian geometry, a system beginning in fantasy and ending in reality? William 8 and many others admit that their assumptions may appear unrealistic, but argue they need not be absolutely accurate-this is a virtual impossibility. They point out that "the final test of a model is not how reasonable the assumptions behind it appear to be, but whether the model actually works." They add that this point has been expressed with great clarity and persuasiveness by Milton Friedman: "The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximations for the piupose in hand. And die question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions."

This brings us to the critical test of both EMH and MPT. Do they yield "sufficiently accurate predictions"? Or have their adherents thrown themselves to their own lions?

Problems, So Many Problems

EMH and MPT are based on the idea that men and women are rational creatures who are risk-averse by definition. People will only take greater risk if they can receive higher retums, and they will take the minimum risk at any level of retum. So goes the theory.

Prior to these theories the existence of rationality could not be proved or disproved in any other area of economics. With the evolution of the social sciences and particularly the various branches of psychology, the assumption of rationahty has come under heavy fire. Thus there has been an interminable debate between economists and other behavioral scientists about whether man is or is not rational, and an exhaustive number of books and articles written on the subject.

The failure of these methods also has wide-ranging implications for both investment and economic theory as we enter a new century.