On the way to his Nobel Prize, Professor Vernon Smith demonstrated that this phenomenon extends beyond boarding planes. There are situations in which the outcome is efficient beyond any reasonable expectation. Professor Smith’s work concerned the magical ability of supply and demand to meet.
The question that Professor Smith addresses relates to the following joke: How many economists does it take to screw in a lightbulb? None; the invisible hand will do it.
Similarly, how is it that I can walk into the small convenience store in my condominium building five minutes before it closes and know that I will find Ben & Jerry’s chocolate fudge brownie ice cream? The answer is that, as Adam Smith wrote, the self-interest of the store owner, working within a framework of law, almost magically provides the goods that I desire (or in this case, the ice cream that my wife Barbara desires).
Professor Smith found that supply and demand work even better than expected. Economists have proven that supply and demand work well when people are rational and have excellent information about the world. Professor Smith’s work showed that even when people know nothing about their world (and are irrational), supply and demand do work their invisible magic. Collective efficiency sometimes arises from individual ignorance and irrationality.1
Even with the evidence that individuals are crazy, it is possible that collections of individuals, operating in markets, will make rational financial decisions. The question remains: Are financial markets more similar to stampedes where small problems multiply, or to miraculous plane loadings where crazy people are guided to efficient outcomes?
The Efficient Markets Hypothesis
The standard view in finance is that markets remove individual irrationality. This “efficient markets hypothesis” says that just as self-interest allows me to find my wife’s ice cream in the local store, prices are pushed to the “right” level by an efficient and invisible hand.
I recently employed a variant of the efficient markets hypothesis in a mundane setting. The trustees of my condominium complex renovated a little exercise room and during the process removed the chin-up bar: the one piece of equipment that I used regularly. To lobby for a new chin-up bar, I attended a trustees’ meeting. During the meeting, I was surprised to find that the trustees were considering spending almost half a million dollars (some of it mine) to buy an apartment for our superintendent.
Among the justifications for this purchase was an analysis that said buying the apartment was a “can’t lose” proposition. Since our building is near both Harvard and MIT, demand for housing was sure to be strong and the apartment’s price would definitely increase, or so the argument went.
Even though I wanted to discuss biceps, I found the lure of the “can’t lose” investment compelling. Accordingly, I asked, “If the price of the apartment is so low that it will definitely rise, why is the owner willing to sell?”
The trustees found great wisdom in this question and invited me to attend future meetings. There is indeed wisdom in my question, but the credit goes to a Frenchman named Louis Bachelier, not to me.2 While he was a graduate student about 100 years ago, Bachelier asked a variant of this question about financial markets.
When two people trade with each other, Bachelier suggested that a good deal for one means a bad deal for the second. Thus, when two people each seek profit, all trade between them should take place at the right prices.
Price changes must occur, Bachelier reasoned, because of new information. In other words, only unexpected news should change the prices of stocks, houses, bonds, and other assets. Since price changes come only from unexpected new information, Bachelier deduced the heretical claim that it is impossible to predict price changes. Similarly, efficiency in the housing market would suggest that “can’t lose” propositions are not available.
Interestingly, Bachelier’s idea, which is now the conventional wisdom, was extremely unorthodox in his time. Even his advisors criticized his work, and his results were ignored to a large extent. Bachelier lived out the rest of his life in relative obscurity, and he died without fame in 1946. Not too long after his death, however, the concepts that Bachelier invented were reformulated as the efficient markets hypothesis that swept through universities and onto Wall Street in the 1970s.3
In the words of Burton Malkiel, author of A Random Walk down Wall Street, the modern version of Bachelier’s insight is “Even a dart-throwing chimpanzee can select a portfolio that performs as well as one carefully selected by the experts.” Malkiel’s book was published in 1973, and it was part of an enormous intellectual wave that restructured the investment world.4
If the efficient markets hypothesis is true, then an investor need never fear buying overpriced stocks. According to the hypothesis, stocks are never overpriced and markets can never be mean.
During the great bull market of the 1980s and 1990s, belief in market efficiency and stock ownership soared. On the 1998 edition of Professor Jeremy Siegel’s Stocks for the Long Run, the dust jacket proclaims, “stocks are actually safer than bank deposits!” (Emphasis and exclamation point in the original.)5
The idea that stocks are safer than bank deposits sounds a bit silly today (and has been removed from the dust jacket of later editions of Professor Siegel’s book). Nevertheless, if markets are rational, then Professor Siegel’s advice that “stocks should constitute the overwhelming proportion of all long-term financial portfolios” might be reasonable.
If markets are not rational, however, then investors ought to worry about buying stocks at irrationally high prices. They should also worry about selling stocks at irrationally low prices. They should also be concerned about the prices of houses, bonds, gold, and all assets.
The essence of the efficient markets hypothesis is realizing that a good deal for one person implies a bad deal for the other. Thus, no one should be willing to sell at irrationally low prices and no one should be willing to buy at irrationally high prices.
The efficient markets hypothesis is a beautiful theory. Is it true?
If She’s Got Pictures, Deny It! . . .
It wasn’t me.
The pop star Shaggy gives this advice to men caught cheating. “Honey came in and she caught me red-handed, creeping with the girl next door.” The correct response to being caught cheating, according to Shaggy? Deny by saying “it wasn’t me.” Even if caught on camera, Shaggy sticks to his defense of “it wasn’t me.”
The great comic Lenny Bruce expressed a similar philosophy in one of his routines: “There’s this kind of guy who says: ‘When I chippie on my wife, I have to tell her, I can’t live a lie, have to be honest with myself.’ ”
To which Bruce replies, “Man, if you love your old lady, really love her, you’ll never tell her that! Women don’t want to hear that! If she’s got pictures—deny it! . . . Gee, honey, I don’t know how this broad got in here—she had a sign around her neck, ‘I am a diabetic—lie on top of me or I’ll die.’ No, I don’t know how I got my underwear on upside down or backwards.”
Those who defend the efficient markets hypothesis use a similar tactic of denial. In response to evidence of market irrationality, the response is denial. (It wasn’t me.)
There are examples of market irrationality that appear as convincing as photographic documentation of infidelity, and they are everywhere around us. For example, financial bubbles have occurred in every society throughout history that has had markets. The most famous case is the seventeenth-century Dutch “tulipmania.” In 1635, at the height of speculative frenzy, the price for a single tulip bulb exceeded that of a nice house in Amsterdam.6
How could it be rational to buy a tulip bulb for the price of a house? This seems particularly strange given that one tulip bulb can produce an infinite number of baby tulip bulbs. While tulips may not breed like rabbits, they do multiply rapidly and thus high prices are impossible to sustain. In fact, the Dutch tulip crash came swiftly, with some varieties losing 90% of their value in a matter of weeks. (By comparison, after it
s peak in 2000, it took Sun Microsystems two years to lose 90% of its value.)
The high price of tulip bulbs before the crash and their rapid decline appear to be evidence of market irrationality. As we will come to see, true believers of the efficient markets hypothesis deny that bubbles and crashes imply that markets are irrational. (It wasn’t me.)
While markets continue to behave as they have for centuries, the debate on irrationality has changed dramatically in recent years. The field of behavioral finance has produced new, scientific evidence of market irrationality. In many cases, the new studies provide statistical confirmation of folk wisdom.
Let’s take a look at some compelling evidence of market irrationality—both historical and new—and the response of those who deny it. (If you are already convinced that markets are irrational, you can jump down to the section entitled “Why Professors Fly Coach and Speculators Own Jets.”) I argue that it is impossible to prove that markets are irrational, but the evidence is compelling. To which, of course, true believers in the efficient markets hypothesis will reply: It wasn’t me.
Claim #1: Stock Market Crashes
On Monday, October 19, 1987, the Dow Jones Industrial Average lost 23%. By noon of the following day stocks faced a crisis where some people feared a total collapse of the stock market. The U.S. Federal Reserve, led by a recently appointed Alan Greenspan, rode to the rescue by guaranteeing certain trades. The market recovered in the afternoon of October 20.
Many people have investigated the 1987 stock market crash. Of note, independent studies were performed by Professor Robert Shiller, the author of Irrational Exuberance, and by his friend Professor Jeremy Siegel, the author of Stocks for the Long Run.7
These two leading academics are often on opposite sides of the stock debate. Professor Shiller argued (correctly so) that stocks were overvalued in the late 1990s. On the other hand, Professor Siegel has maintained a uniformly positive view of stocks, before, during, and after the bursting of the bubble in 2000. Because of their opposing views on the prospects for stocks, they are often contrasted as leaders of the bear and bull camps.
When it comes to the crash of 1987, however, Professors Shiller and Siegel agree. The crash was not caused by any rational factor such as a news event. Professor Shiller summarizes his findings as, “No news story or rumor appearing on the 19th or over the preceding weekend was responsible for investor behavior.”8 Similarly, Professor Siegel writes, “No economic event on or about October 19, 1987 can explain the record collapse of equity prices.”9
As most of us know all too well, starting in 2000 the NASDAQ suffered a decline that was less dramatic than the 1987 crash, but more severe and longer lasting. Table 3.1 shows the performance of leading stocks sometimes called the “four new horsemen of the NASDAQ.”
These figures suggest that either precrash prices were irrationally high or postcrash prices irrationally low. When Cisco was priced at $80, the evidence suggests that the stock price was irrationally high. Similarly, when Cisco was trading at $8, after the bubble burst, the evidence suggests that the stock price was irrationally low.
The Denial: The believers in the efficient markets hypothesis deny that sudden price changes indicate irrationality. Furthermore, they claim that Cisco’s stock price (and all other prices) were correct at the time. Thus, they argue that the decline in Cisco’s price from $80 to $8 was caused by unexpected information that was unknowable at the peak.
TABLE 3.1 The Decline and Partial Recovery of the Four New Horsemen of the NASDAQ
Source: The Wall Street Journal
This claim is based on the fact that stocks discount the future. For example, the value of Cisco in 2000 depends on China’s attitude toward imports in 2010, so even small changes in investors’ expectations about China’s future import policy can cause big changes in Cisco’s value. Even huge price changes can be rational when nothing concrete changes in the world.
Thus, even though Professors Shiller and Siegel cannot identify the cause of the 1987 crash, it can be explained as a rational response to expectations about the future. Since we can’t know what those expectations are, we can’t conclude that the sudden changes in stock prices are irrational.
Photographic Evidence: Asset Bubbles in the Laboratory
In the real world, we can never prove that bubbles and crashes are caused by irrationality. It is possible that real world crashes are caused by changes in unknowable variables. To investigate bubbles, economists have built artificial stock markets where everything is known. In these laboratory markets, bubbles and crashes, if they exist, must come from inside people.
In fact, Professor Vernon Smith and others have found that even artificial stock markets exhibit bubbles and crashes. In these experiments, people trade a stock for real money. In contrast to the actual stock market, the traders in these artificial markets know the true value of the stock. Nevertheless, traders in these artificial markets push stock prices up to irrationally high prices and then the prices crash.10
In the artificial markets, there is no explanation for the bubbles and crashes other than the fact that they arise naturally as part of human nature. True rational market believers argue that the markets are artificial and, in the real world, people who trade at irrational prices would be weeded out.
It wasn’t me.
Claim #2: Markets Are More Than Simply Irrational—They Can Be Mean
Investors seem to have an uncanny ability to be wrong about investments. We tend to be optimistic about stocks just before market collapses and pessimistic just before bull markets. Consider the experience of U.S. investors in the period from 1965 to 1981 as shown in Figure 3.1.
The Dow Jones Industrial Average ended 1965 at 969, and 16 years later the index stood at 875. Almost an entire generation passed with the stock market going absolutely nowhere. Near the end of this period, people essentially forgot about stocks, and in 1980 only 5.7% of households owned any mutual funds.11
FIGURE 3.1 A Generation without Stock Market Gains
Source: Dow Jones
In 1979, BusinessWeek printed its now infamous “Death of Equities” issue suggesting that investors avoid stocks. The cover image was a crashing paper airplane, created from a stock certificate. Stocks were destined to be bad investments, opined the magazine, for the foreseeable future, and “the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared.”12 The pervasive pessimism about stocks in the late 1970s coincided with the best buying opportunity of the century, as shown in Figure 3.2.
As we see in Figure 3.2, from the end of 1981 until today, the Dow has yielded more than 1,000%, and this calculation does not factor in dividends. As the stock market rose throughout the 1980s and 1990s, the attitudes toward stocks shifted from gloom to glee. Investors gradually increased stock purchases. By the time the stock market peaked in 2000, almost half of U.S. households were invested in mutual funds.13 At the same time, Wall Street firms were advocating 70% investment in stocks, among the highest figures on record.14 The peak enthusiasm for stocks reached in 2000 corresponded with the beginning of one of the worst bear markets since the Great Depression.
FIGURE 3.2 The Mother of All Bull Markets Started When Stocks Were Hated
Source: Dow Jones
Sentiment is a predictor of future returns. Optimistic periods tend to be followed by bad performance, whereas pessimism tends to dominate before good things happen. Wall Street is driven by greed and fear. The funny thing is that our lizard brains tend to make us greedy when we ought be fearful, and fearful when we ought be greedy.
Our ability to be excited at the wrong time extends to individual stocks. Professor Terrance Odean examined the actual trading records of 10,000 ordinary investors.15 He focused part of his study on investors who sold one stock and then bought another stock within a few days. He compared the performance of the stock that was sold with that of the stock that was purchased.
How did the investo
rs in this study perform? Remember that if markets were rational, then the stocks that these investors sold would have had the same return (on average) as the stocks that the investors bought. What happened? Professor Odean writes, “over a one-year horizon, the average return to a purchased security is 3.3 percent lower than the return to a security sold.” So these investors became excited enough to buy and pessimistic enough to sell stocks at the wrong time. Their sentiment was an inverse predictor of success.
The efficient markets hypothesis is usually employed to suggest that bargains are impossible. “Don’t waste your time looking for cheap stocks; if they existed someone else would already have bought them.” The converse is also true, but rarely mentioned; if markets were rational, then it would be equally impossible to make systematically bad decisions. “Don’t waste your time worrying that you might get excited at the wrong time and buy expensive stocks; if they existed someone else would already have sold them.”
Mean Markets and Lizard Brains Page 6