Chaplin’s mask illusion is a stark illustration of the importance of prior beliefs. People are very sensitive face detectors. We are able to distinguish among a countless number of faces, although most of them share the same basic components. One thing all faces have in common is that they are convex. There is no such a thing as a concave face. So the Base Rate of the hypothesis that a face is convex is 100%. From Bayes’ Theorem:
If the Base Rate is 1, the Posterior Probability of the hypothesis is also 1, irrespective of the values of the True Positive Rate and the False Positive Rate. That’s why our brain refuses to see a concave face mask (and needs to be told by different means). This is Faith: a prior certainty that no amount of evidence, however strong, can change.
Faith in the Efficient Market Theory works in the same way. So when Richard Thaler remarks that one cannot seriously claim that markets were equally efficient with the NASDAQ at 5000 and at 1400, Eugene Fama’s reply is emblematic:
Stock prices depend on two factors: expected profitability and the expected returns investors require to hold stocks. Both can vary dramatically through time. Thus, widely different levels of the market at different times are quite consistent with market efficiency. Indeed, they are required for market efficiency. This might well be a tough sell, but it’s Finance 101.
That’s it. The EMT is a Faith, and even the most blatantly obvious counterevidence is “explained” away. There will always be a combination of expected profitability and expected returns that is consistent with any market level. If the NASDAQ had gone up to 10000 and down to 500, Fama’s reply would have been exactly the same.
Likewise, the long term track record of many successful investors should leave no doubt that it is possible (though certainly difficult) to beat the market. But Faith is impervious to all evidence. There is an Italian expression to describe the naive attempt to counteract a critic by turning his argument around and using it against him. I am struggling to translate it. In Italian we say “rivoltare la frittata”, literally “flipping the omelette”. This is what Fama does to dismiss George Soros’ criticism of the EMT:
All the evidence I know says that market predictions are unbiased. It’s understandable, however, that hedge fund managers are immune to this evidence since it’s a threat to their existence.
Yeah, right… According to Fama, George Soros is just a lucky guy. And so is, of course, Warren Buffett. Read this amazing interview. The interviewer asks Fama about Buffett. Here is his mindboggling answer:
He is a business person, he is not an investor. He buys whole businesses and I would imagine he helps to run them – you don’t buy whole businesses and then don’t say anything [laugh].
Of course, as anybody who knows anything about Buffett can easily attest, the reality is just the opposite. Buffett must have said it and written about it a thousand times: he is a hands-off investor. But never mind – businessman or investor, Buffett is just one lucky guy on the tail of a random distribution. Don’t be swayed by Fama’s rhetoric when he says that he doesn’t know whether Buffett is skilled or lucky and would like to test, but lack of data makes testing impossible, etc. What he is really saying is that Buffett is no proof that the EMT is wrong. Amazing.
Notice in Bayes’ Theorem that BR=1: “I am certain that faces are convex” or “I am certain that markets are efficient” has the same effect as FPR=0: “I have never made a mistake by calling a face convex” or “I have never made a mistake by calling markets efficient”. They both imply that the Posterior Probability PP equals 1. Faith is the same as Denial: in front of a concave face our brain says: It can’t be true, it is convex. In front of Warren Buffett, Fama says: It can’t be true, markets are efficient.
This is Eugene Fama, by far the world’s most quoted and authoritative financial theorist. So when smart people outside Finance look for what respected academics say about financial markets, they immediately encounter the Efficient Market Theory and, quite reasonably, assume that it is the standard, consensual theory of market behaviour. See, for example, here and here. Propaganda Fide.