Jewish World Review March 21, 2001 / 26 Adar, 5761
http://www.jewishworldreview.com -- HANK, a friend of mine who trades stocks for a living, has a motto that he always repeats to his trainees: "The market can stay irrational for longer than you can stay solvent." This marvelous aphorism is applicable to many things in life besides stocks; indeed, in regard to financial markets, Hank intends the phrase ironically.
Hank's view, which mirrors that of almost all academic analysts of the market, is that in the long run financial markets are extremely rational. Another one of his favorite sayings is that "in volatile markets money flows back to its rightful owners." This is because, while markets are rational, most people are not.
Perhaps the best example of this paradox of rational markets full of irrational investors is the widespread belief that it makes sense for ordinary people to try to pick stocks. If finance theory has proven one thing, it is that this belief is simply, demonstrably and necessarily false.
It may make sense for professional money managers to spend their time trying to beat the market (in fact there is a great deal of evidence that it does not make sense), but for somebody who doesn't spend at least 60 or 70 hours a week analyzing stocks to try to do so is just nuts.
Think of it this way: there are hundreds of thousands of extremely smart and superbly well-informed people professional investors - who spend their lives doing nothing but trying to beat the market. The idea that ordinary investors have any chance of winning at this game for any reason other than sheer dumb luck is nonsensical. It's the equivalent of a weekend golfer thinking that if he just goes out to the practice range a couple times during the week he'll have a decent shot of beating Tiger Woods on Sunday afternoon.
Of course the difference between golf and investing is that, while golf is a relentlessly unforgiving game, it's easy to confuse the rising tide of a bull market with one's own supposed money managing skills.
The technical name for this observation is the Efficient Market Theory. EMT comes in several variations, but the basic point is simple, elegant and devastating to the pretensions of just about everybody this side of Warren Buffet: Subject to a few exceptions not relevant to the vast majority of investors, present stock prices already reflect all of the available information regarding future stock prices. Furthermore, the transactions costs of acting on new information almost always outweigh the investment value of acting on the new information.
Put these two points together, and the theoretical conclusion is that throwing darts at a stock chart is just as good a method for making investment decisions as poring over price-earning ratio tables (actually, it's a better method, because it's cheaper).
This theory has been tested empirically many times (indeed, for many years the Wall Street Journal featured a money managers versus the dartboard contest). The results of these tests are clear: Over time, the darts do as well as the most famous and highest-paid professional fund managers.
Why then do people continue to try to pick stocks themselves, or, worse yet, pay others to pick stocks for them? The answer, I think, has something to do with the comfort of ritual.
In some cultures, men paint their faces and dance around fires to keep away the dark spirits that inhabit the howling wilderness. In ours, we engage in the rituals of rationalism. The ritualistic "predictions" of the stock analysts on any of a dozen cable channels have no rational basis but they comfort us all the same.
Nevertheless, I could swear Lucent is significantly undervalued right
Paul Campos is a professor of law at the University of Colorado. Comment by clicking here.
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