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Consider John Maynard Keynes's well-known beauty contest metaphor for the stock market. In the contest, each judge picks the candidate he or she thinks others will pick rather than the candidate he or she thinks should win on merit. This replaces a fundamental or substantive sort of analysis (of the kind urged in this book) with a popular, speculative, and herd-pack mentality.

The 1981 Nobel laureate James Tobin of Yale took Keynes's beauty contest a step farther. He suggested that even if a public capital market is efficient in the sense of swiftly incorporating public information into stock prices (i.e., the semistrong form of EMT), that does not necessarily mean that stock prices in that market reflect fundamental values (i.e., the present value of expected future flows to stockholders).

The quality of information digested by the market may be just as low as the quality of information that goes into the decisions of Keynes's beauty contest judges. Tobin has many followers who think he's right, including Nobel Prize winners William F. Sharpe and Kenneth Arrow of Stanford. 11 If it is true that many traders act as Keynes described, the semistrong form of EMT has to be further subdivided between strict informational efficiency and a more refined notion of fundamental efficiency.

Informational efficiency describes a market in which all public information about a stock is reflected in the price of that stock without regard to the quality of that information. Thus, information that concerns the fundamental value of a stock is reflected, but so is information wholly unrelated to that fundamental value, such as who won the Super Bowl. Fundamental efficiency is the more narrow but more ambitious idea that stock prices are accurate indicators of intrinsic value because they reflect only information concerning fundamental business values. 12

The issue becomes whether the capital markets can distinguish among kinds of information so that only information about fundamental value is impounded and reflected in prices. That revives the basic question of whether humans behave rationally. EMT says it does not matter if individual actions are not rational because any individual irrationality will be corrected by others acting rationally. In effect, irrationally is "assumed out" of the EMT model.

The informational-fundamental distinction, however, is so intuitively and empirically potent that it had to be confronted. The result was the face-saving shelter of euphemism: The economist Fischer Black, borrowing a term from the field of statistics, renamed irrational behavior noise, thus enabling self-respecting economists to discuss the issue and try to model it. 13

Noise theory is supported by substantial empirical evidence and a well-developed intellectual foundation. Noise theory models hold that stock markets are infected by a substantial volume of trading based on information unrelated to fundamental asset values (noise trading). These models attempt to explain both why noise trading occurs and why its effects persist.

The most common noise theory model says, for example, that noise trading is conducted by ill-informed investors who act on sentiment rather than rational analysis. Their actions move prices away from fundamental values. The price-value gap persists despite the presence of sophisticated arbitrageurs because they are risk-averse and cannot be sure that investor sentiment will not change adversely at any time. 14

Evidence of the noisy investor approach to the stock market includes following tips or acting on rumors, rapidly turning over one's portfolio, selling good performers while retaining bad ones (thus triggering taxable gains rather than generating tax-deductible losses), paying huge mutual fund fees for poor managerial performance, and imitating others in running off market cliffs by using silly technical trading strategies.

The causes of this behavior remain poorly understood, but psychological research suggests a number of tendencies. These tendencies include attitudes toward risk that lead people to be more averse to loss than eager for gain; this explains the irrational tendency to hold losing stocks while selling winning stocks. Another is skewing the probabilities of uncertain future events by basing forecasts on past patterns, such as by forecasting that earnings growth over the next ten years will equal that of the last three.

In theory, smart money arbitrageurs could correct all these errors and profit from them, keeping EMT intact. But this is a risky business. If there is mispricing today, there may be mispricing tomorrow. If stocks are highly priced compared to value, an arbitrageur will sell short and await the correction. But the correction may not arrive before she has to cover. If stocks are lowly priced compared to value, an arb will buy and await the rise. But that correction could take a long time, during which those funds could be deployed at higher returns elsewhere.

Another possibility is that individual actions that are rational can produce aggregate results that are irrational. This happens all the time in business. After air-conditioning was invented, for example, retail stores spent substantial sums to install it, but once every store did this, none of them enjoyed any competitive advantage as a result. It is why you see a gas station at every corner of a suburban intersection. Buffett gives the example of what occurs when each person watching a parade decides he or she can see a little better by standing on tiptoe.

Despite these profound insights developed at the frontiers of thought about how markets work, they continue to be treated by many leading economists as variations on the theme. Maybe there is some deviation in EMT, its devotees admit, but the deviations are due to mere chance. Eugene Fama, for example, continues to argue that apparent overreaction to information is just as common as apparent underreaction to information, and the likelihood of abnormal returns continuing after an event are about as likely as those returns reversing after that event.

Thus, a whole group of leading economists thinks that the latest evidence against EMT does not add up to much. They cling to investment tools that are based on EMT and used to complete the theoretical picture with practical applications.


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