Markets are not efficient because human beings are not as rational as the Efficient Market Theory requires them to be. As Richard Thaler puts it, investors are Humans, not Econs. Daniel Kahneman is the beacon of this idea. His work with Amos Tversky, started in the 1970s, has opened an entire field of research which bears the ugly name of Behavioural Finance. Starting from the assumption that investors, and therefore markets, are subject to cognitive biases, it is a logical step to conclude that avoiding these biases – as hard as it is – can give investors an edge to success. Ben Graham can be read in the light of this principle. Kahneman and Tversky, and the ensuing literature, provided solid grounds to Graham’s earlier psychological insights.
How puzzling, then, to read in Kahneman’s book:
In its broad outlines, the standard theory of how the stock market works is accepted by all participants in the industry. Everybody in the investment business has read Burton Malkiel’s wonderful book A Random Walk Down Wall Street. Malkiel’s central idea is that a stock price incorporates all the available knowledge about the value of the company and the best predictions about the future of the stock. If some people believe that the price of the stock will be higher tomorrow, they will buy more of it today. This, in turn, will cause its price to rise. If all assets in a market are correctly priced, no one can expect either to gain or to lose by trading. Perfect prices leave no scope for cleverness, but they also protect fools from their own folly (p. 213).
The successful funds in any given year are mostly lucky; they have a good roll of the dice. There is general agreement among researchers that nearly all stock pickers, whether they know it or not – and few of them do – are playing a game of chance (p. 215).
Why do investors, both amateurs and professional, stubbornly believe that they can do better than the market, contrary to an economic theory that most of them accept, and contrary to what they could learn from a dispassionate evaluation of their personal experience? (p. 217).
Kahneman believes that markets are efficient in the usual sense, and that the only bias that investors need to avoid is the Illusion of Validity, i.e. the illusion that they can beat the market, a skill which he believes is not just difficult to achieve but impossible a priori.
This is disappointing. Professor Kahneman should consider that:
- It is not true that everybody accepts the Efficient Market Theory. Many investors think that markets are not efficient, precisely because Humans are not Econs.
- If markets are not efficient, prices are not perfect and assets are not always correctly priced.
- The Illusion of Validity is pervasive, and beating the market is difficult – no one denies it. But it is wrong to say that it is impossible. The long term track record of many successful investors proves it. To say that they are just lucky is frivolous.