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Investors Are Finally Seeing The Nonsense In The Efficient Market Theory

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http://www.telegraph.co.uk/finance/comment...ket-theory.html

The best response I've heard to the efficient markets theory that has dominated thinking about investment for 30 years or more is a joke. Two men walking down a street spot a £20 note on the pavement. One, an economics professor, says to the other: "don't bother to pick it up – if it were really a £20 note it wouldn't be there".

He means that because market prices always capture everything anyone knows about a share or index there can never be any hidden value for a shrewd investor to "pick up". It is nonsense, of course - like telling Warren Buffett that all the investment opportunities he's been exploiting over the years can't logically exist. But when has being nonsense ever stopped people believing something?

In this context, it was interesting to see a report this week that the Chartered Financial Analyst Institute, which has been teaching efficient markets theory for decades, has admitted that most of its members have lost the faith. Two thirds say they no longer believe market prices reflect all available information and three quarters disagree that investors as a whole behave "rationally".

What's amazing is that it has taken so long for the penny to drop. It has seemingly required investors to lose their collective senses twice in a decade (dotcom bubble, housing boom) for people to realise that the crowd is mad as often as it is wise.

Markets have always been prone to bouts of "irrational exuberance". The price of tulips in 17th century Amsterdam, that of South Sea Company stock in 18th century London and of Florida real estate in the 1920s are just highlights of the procession of booms and busts down the ages that has taught every subsequent generation that markets often get it wrong.

They do so for two reasons. They get it wrong because they reflect human behaviour in all its fearful, greedy irrationality. And they get it wrong because they reflect a world that is inherently unpredictable.

This is why, for all my rude comments last week about technical analysts' "dirty raincoats and large overdrafts", sensible investors take account of both the fundamentals (sales, profits, balance sheets and so on) and the charts of price movements. Those charts are no more nor less than snapshots of the millions of fearful, greedy decisions made by investors every minute of the day and, as such, they tell a fascinating tale to anyone who learns their language.

There are many reasons why those decisions are invariably irrational. These heuristics, or psychological biases, are beginning to be unpicked by the new science of behavioural finance.

One is "anchoring", the tendency of people to measure the value of an asset against some wholly irrelevant number. A study of this asked groups of people to estimate the number of doctors in London but only after they had first provided the last four digits of their phone number. People with the highest phone numbers consistently gave higher estimates of the number of doctors. Completely irrational, of course, but no different from fixating on RBS's share price two years ago when assessing whether it is good value now.

There are many more of these biases, often relating to over-confidence: most people think they are better than average investors just as they over-estimate their driving ability but we can't all be better than average. We are overconfident about forecasts and in the power of systems – securitisation of dodgy mortgages spreads and so reduces risk, doesn't it?

So, increasingly few people still believe that markets are wholly efficient and that is a good thing. It means fewer people will believe, as governments and regulators did, that the prices of loss-making internet stocks in 1999 and Miami condominiums in 2006 were in any way not a disaster waiting to happen.

It might mean that fewer people are tempted by passive investments which promise an answer to the awkward fact that most active fund managers do not beat the market but can only do so by guaranteeing that you will hold all the market's very worst stocks as well as its good ones.

However, there is one problem with dismissing out of hand the efficient markets theory. It is that markets are not so inefficient that anyone can safely bet against them. Assuming that you know more than the market is a dangerous game to play when most of the time most of the information is accurately factored in.

The answer is not to give up trying to beat the market but it argues for finding someone who, because of their skill, knowledge or intuition, is good at spotting the £20 notes on the pavement – and sticking with them.

Markets have never been efficient, on paper they might be in reality too many variables stop markets from functioning perfectly.

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http://www.telegraph.co.uk/finance/comment...ket-theory.html

Markets have never been efficient, on paper they might be in reality too many variables stop markets from functioning perfectly.

That's just it. One cannot depend on the honesty of the seller, and the intermediaries morality by nature will be a small fraction of that.

So that is trust out of the window.

Greed. How does one control such a primal human instinct?

The markets are rigged and always will be.

Edited by cashinmattress

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I was walking down a street in Colchester once when I saw a £2 coin on the pavement outside a bar. I bent down to pick it up only to realise it had been glued to the floor. A group of drinkers in the bar had had some fun at my expense.

So what's the connection?

Sometimes the market is rigged to fool the greedy and the gullible. Bulls be warned.

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I was walking down a street in Colchester once when I saw a £2 coin on the pavement outside a bar. I bent down to pick it up only to realise it had been glued to the floor. A group of drinkers in the bar had had some fun at my expense.

So what's the connection?

Sometimes the market is rigged to fool the greedy and the gullible. Bulls be warned.

You should have found something heavy to hit the coin with and claim your £2. :P

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I was walking down a street in Colchester once when I saw a £2 coin on the pavement outside a bar. I bent down to pick it up only to realise it had been glued to the floor. A group of drinkers in the bar had had some fun at my expense.

So what's the connection?

Sometimes the market is rigged to fool the greedy and the gullible. Bulls be warned.

Oh dear, I probably shouldn't tell this one....but...

A few years ago when I was in the forces, a group of us sailors ended up in some crappy strip bar in some god awful port town...doesn't matter where of course...

But, one of the ladies had a talent for picking up the local currency from the dance floor with her...ummm....let's say cash box...

So, one of my mates decided to 'pre-heat' a few coins with his zippo lighter...

Oh dear. It didn't end well for anybody that day.

Memories....

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The only sure-fire way to make money from a market is to be involved in setting the conditions for that market, or to charge people for your "expertise" or access.

I always compare it with who makes money from horse-racing - owners, trainers, bookies and tipsters.

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One is "anchoring", the tendency of people to measure the value of an asset against some wholly irrelevant number. A study of this asked groups of people to estimate the number of doctors in London but only after they had first provided the last four digits of their phone number. People with the highest phone numbers consistently gave higher estimates of the number of doctors. Completely irrational, of course, but no different from fixating on RBS's share price two years ago when assessing whether it is good value now.

Such as the price of a house in summer 2007, for instance

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The only sure-fire way to make money from a market is to be involved in setting the conditions for that market, or to charge people for your "expertise" or access.

I always compare it with who makes money from horse-racing - owners, trainers, bookies and tipsters.

you are forgetting the Cartel, all merchants guilds, trade associations, industry groupings (and i would include political groupings) meet together to cheat the public, they never get together to improve the lot of the people. they are self serving minority interest groups whose only interest is in their own self preservation.

It is this instinct for survival that drives the market, and the determinitaion to destroy your competitor is part of this survival instinct. There is nothing magical or mystical about "markets", they are driven by fear and greed.

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http://www.telegraph.co.uk/finance/comment...ket-theory.html

Markets have never been efficient, on paper they might be in reality too many variables stop markets from functioning perfectly.

Agree totally, because as already highlighted by many on this thread they apply the wrong model to markets, most people apply the economic model which is fundamentally wrong, markets work on a socionomic model of human emotion rather than cold hard facts.

Prime example in economics low prices entice more buyers,but with speculation and markets it is the opposite, high prices entice more buyers hence why bubbles occur

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Markets have never been efficient, on paper they might be in reality too many variables stop markets from functioning perfectly.

Markets are only (largely) efficient when they're free: the more government interferes, the less efficient they become.

Glaring examples are insider trading laws which pretty much ensure that only the people _least_ well informed about the company will be trading shares, and tax-relief for pensions which encourages people to throw vast amounts of money at pension companies who have to put the damn stuff somewhere even if there's no rational reason to pay $500 a share for widgets.com.

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