Behavioral Finance

"Markets are not about math, they are about psychology, and although, in a lot of ways, the market may be very efficient it certainly is not rational. The market is very efficient at registering not only the value of the stock but also the current mood of 'Mr. Market.' The price of a stock at any given point can be seen to have two components 1. Its value, and 2. A psychological component determined by the degree of mania or panic prevalent in the mind of the participants." Behavioral Economics And Educated Capital Markets

 

You don't know what a company is going to earn next year, but you can make a reasonable guess. You do not make a decision to buy a stock because of what the company is going to earn 12 months out. You want to buy companies that you can hold for years, so when you pick a company to buy, you are making assumptions about what that company will be doing five or ten years from now. Managing money is not rocket science, but it takes lot of work. Patience is more important than a degree in mathematics, and experience is vital. But the argument that outperforming the market is statically impossible is nonsense—a triumph of academic theory over simple logic.

Graduate schools teach that the markets are efficient—that stock prices accurately reflect all information that is available. But how can you reconcile this with Ben Graham's bipolar Mr. Market who is wildly optimistic one day and violently depressed the next. l admit to having been attracted to EMT theory when I first read about it. On the surface it seemed to make sense. Eight years of employment as a broker from 1967 to 1975 had taught me a great deal of respect for the markets and absolutely none for market analysts. Markets are like women; if you want to get along, you have to learn to listen to what they say, and a prolonged period of disagreement can only lead to grief.

 

Respect for the messages from the market is absolutely vital to investment survival. But EMT goes way beyond respect, and attempts to make the study of the market a science. This in turn leads people to foolish conclusions, such as (a) Warren's Buffett's record can be explained by luck. Even worse is the assumption that (b) the best place for serious money is index funds, or that (c) a tech stock with no earnings can be worth tens of billions of dollars because the market says it is.

 

To Charlie Munger the Efficient Market Theory, and "Modern Portfolio Theory" are "twaddle." Graduate business schools attempt to make investment analysis seem a lot more complicated than it really is. It is Charlie's contention that the main reason for this, is an attempt by these very expensive schools to justify the tuition they charge. Markets (and economics) are not about science, they are about psychology. On Charlie's side is Jeremy Grantham who says,

"I believe that markets are usually inefficiently (emphasis added) priced, both in detail and in aggregate, and that they are driven by very fallible, emotional investors who have neither the mathematical nor the psychological means to process data efficiently in economic terms, nor, in the case of professionals, the incentive." "Ivory Towers" by Jeremy Grantham

 

Practitioners of EMT want to quantify everything. They have formulas for everything. "To the man with a hammer everything looks like a nail." There are formulas for risk, (see Risk Is as Risk Does) formulas for allocation, and formulas to find intrinsic value. Formulas are nice but in this business every thing starts with a guess. And all these formulas are an attempt to deny or to camouflage the real nature of the decision that you are making—to add the illusion of certainty to a process where there is no real certainty. Behavioral Economics And Educated Capital Markets