Why "Efficient" Markets Go Haywire

08/18/2009 9:14 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

So-called efficient market theory sometimes fails—spectacularly—to predict Wall Street's behavior, yet the theory lives on. So what's a rational investor to do?

I remember watching in horrified fascination in October 1987 as the stock market crashed. The Dow Jones Industrial Average dropped 22.6% as $500 billion evaporated in a single day.

As a (relatively) young business editor, I got pressed into service calling up the smartest people on Wall Street to ask them what had happened. Money managers on the Street were in shock. "This can't be happening," more than one told me. "Prices don't behave like this."

"Prices don't behave like this." That phrase connects the financial disasters of the past 20 years, from the collapse of portfolio insurance in 1987 to the collapse of mortgage-backed derivatives in 2007.

It will be the theme song for the next financial market disaster, too, because efficient market theory, the set of assumptions that underpins these events, just won't die. It may be intellectual swiss cheese, but it's far too profitable for Wall Street to let it go.

Rational Market a Myth?

Justin Fox has just published an extraordinarily interesting and readable history of efficient market theory titled The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. Read it and you'll understand how we got here, why Wall Street will keep recreating these disasters, and how you can tiptoe around the worst of the damage.

What Fox is best at is showing the reader the assumptions behind efficient market theory from its development in the 1960s to its triumphant takeover of business schools, Wall Street, and corporate boardrooms in the 1980s. (I had the key formulas of efficient market theory, models such as the capital asset pricing model, drilled into me in the year I spent at business school in the early part of that decade.)

What are some of those key assumptions?

  • That human beings are driven to maximize their self-advantage
  • That human beings rationally decide what their self-advantage is
  • That information flow in financial markets is free and instantaneous
  • That prices always accurately reflect all the available information
  • That markets always clear to equilibrium because enough buyers and sellers will always emerge

Fox is extraordinarily fair to the great names of economics and finance who put this structure in place: Franco Modigliani, Eugene Fama, Merton Miller, Fischer Black, Harry Markowitz, Milton Friedman, Myron Scholes, and others. They never come across as anything other than what they are: Brilliant thinkers who knew they were making radically simplified assumptions about reality so that their models would work.

Fox's most interesting chapters are his discussions of such honest thinkers as Black, who never forgot that his theories were built on simplified versions of reality. I can't imagine being tough enough to constantly question the validity of your life's work, but some of these folks did exactly that.

Events, of course, helped them along, because reality struck back hard not too long after efficient market theory became the ruling orthodoxy. The first of these was the 1987 stock market crash, which was facilitated, if not created, by a financial product called portfolio insurance, built out of the pricing models created by efficient market theory.

Hedge Fund Debt Disaster

Then there was the collapse of the Long-Term Capital Management hedge fund in 1998. Some of the best minds on Wall Street had devised immensely profitable strategies that exploited tiny, unjustified differences in the prices of financial assets such as Treasury bonds with 30 years until maturity and Treasury bonds with 29.75 years until maturity. In the first several years after its founding in 1993, Long-Term Capital averaged returns of 40% annually.

But by 1998, Long-Term Capital had borrowed billions—$124.5 billion, to be precise—to get more bang from the tiny price discrepancies its computers had identified. Then a financial crisis in Russia triggered a chain of events that led to losses at Long-Term Capital of $4.6 billion in less than four months. Prices for its portfolio assets collapsed—which shouldn't happen in an efficient market—and liquidity dried up, which is also not part of the theory. The New York Federal Reserve Bank eventually engineered an orderly unwinding of the fund to prevent its problems from rippling out through the global financial system.

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Tech Stock Bubble Blows up

There are more recent examples, too. Then-Federal Reserve chairman Alan Greenspan's decision not to prick the technology bubble in 1998 or 1999 led to irrationally high stock prices, which then collapsed to irrational lows. Where was the efficiency to a market that valued Cisco Systems at $80.06 a share on March 27, 2000, and at $8.60 on October 8, 2002?

Surely one, or perhaps both, of these prices is better explained by the behavior of lemmings leaping into the ocean than by the rational decision making of efficient market theory.

Debt Derivatives Trigger Panic

And now in the current crisis, investors have received a painful refresher course in how panic—by definition neither efficient nor rational—can so dry up market liquidity that there are no prices, efficient or otherwise, for some assets at all. It's hard to get to price equilibrium when no one is bidding.

Fox's book also makes it depressingly clear why, despite its failures and its role in global financial disasters, efficient market theory isn't about to go away. The theory provides a set of mathematical formulas that let people on Wall Street calculate price and quantify risk for things like options and their increasingly complex descendents in the derivatives world. And the bottom line on Wall Street is that if you can price a product and give it a risk rating, you can sell it.

After watching the flood of profits created by new products that priced the risk of mortgage-backed assets, do you doubt that for a moment?

And as we know so clearly, the rewards for creating profitable instruments based on this flawed theory far outweigh the punishment for being wrong. Sure, a Lehman Bros. goes under, but life and bonuses go on at Goldman Sachs, and even at Merrill Lynch.

What's an Investor to Do?

Fox wasn't out to write a what-do-you-do-about-it book for investors, but a very valuable how-to book logically falls out of his history.

Efficient market theory isn't worthless, Fox points out. Its assumptions are reasonable and its conclusions accurate much of the time. Say, 80% of the time.
Call these normal times. During these times you ought to follow the strategies of the mythical efficient investor by looking for the kind of information arbitrage that efficient market theory predicts will lead to profits. So you can make money during these times by studying global stocks and domestic small caps that few investors follow, by taking a long-term view when everyone else is focused on the short-term, and by digging out technology trends or balance sheet facts that no one else knows yet. Efficient market theory says that you'll get paid for putting that information in play for the larger market so it can bid inefficiencies out of existence.

When to Peel off from the Herd

And then there's the remaining 20% of the time, when investors aren't rational and the herd rushes about from one extreme to the other. At times like these, you can't trust the wisdom of the market, because the herd has lost its bearings. You protect your portfolio from losses by going against the flow, by selectively ignoring the common wisdom and by having the courage to follow your own lonely way.

An example of this? Fox includes a great one. Efficient market theory has spent decades trying to explain away data that shows value investing strategies outperforming growth strategies in the stock market. Turns out, researchers in the new field of behavioral finance have shown to my satisfaction that the outperformance is a result of how hard it is to go against the herd. Value investors have to stand up to the ridicule of the consensus, and that makes them work just a bit harder to justify the courage of their convictions.

So the strategy I come away with after reading Fox is actually very simple: Follow the efficient investing strategies during normal times and invest like a contrarian during the 20% of times that aren't normal.

Now, if someone will just show me an infallible way to tell the 80% from the 20%.

More from Jim Jubak:

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Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, "The Jubak Picks," and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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