A few months ago, in my first tweet, I commented on the just assigned Nobel prize in Economics:
Nobel to Fama and Shiller is like cardinal Bellarmine and Galileo sharing the Nobel prize for Physics.
A couple of weeks later I wrote a post, elaborating on the analogy. Then the other day, still caught in Sir Arthur Conan Doyle’s passionate defence of Spiritualism and his scathing attacks on anyone daring to question its incontrovertible truth, I read:
Is it not time, after seventy years of ever-varying proof, that such an attitude be abandoned? But when it is abandoned, and when the conclusions have been accepted, what an eternity of ridicule is waiting for those solemn Panjandrums of Science who have for long held up their warning hands lest the public should believe the truth! The story of the Italian Cardinals and Galileo will seem reasonable when compared with the attitude of Victorian science to this invasion of the beyond (The Edge of the Unknown, p. 105).
Wow, me and Sir Arthur connected by the same metaphor! Except that he was using it against the common view that psychic phenomena are nor real, and therefore ghosts and fairies do not exist; I was using it against the view, still common, that financial markets are efficient, and therefore beating the market is impossible.
We both believe there is conclusive evidence in our favour, which the Panjandrums of Science dismiss as illusory. We also agree that there is a lot of bogus evidence – assorted tricksters in his case, double-your-money gurus in mine – that is rightfully dismissed. But genuine conclusive evidence – a long list of psychic experiences that could not possibly be fakes; a long list of investors with a certified market-beating track record – cannot be ignored.
So – before the parallel gets uncomfortable – where is the difference? It is that – as Harry Houdini, James Randi and many others have proven and continue to prove – Sir Arthur’s evidence was just a cleverer form of forgery, condemning him, alas, to an eternity of ridicule, gracefully compensated by the eternal delight of his narrative creation.
But the long term track record of successful investors is no hallucination. So what do the Efficient Market Panjandrums (I like the word!) do to dismiss it? They resort to their own sort of trickery: they move the goalposts, i.e. they dismiss it by proving something else. Typically, the proof consists in taking a sample of asset managers – usually with the intent of representing the statistical universe – and showing that, as a whole, they underperform the market, by at least the size of their fees. Nice try. But the hypothesis under investigation is not that all investors, or even a majority of them, outperform the market. It is that some of them do, and therefore beating the market, while difficult, is not impossible. Faced with the hard evidence of outperformance, the defenders of the Efficient Market Faith fall back on two ancillary tricks. The first is to show that outperformance has been obtained at the cost of extra risk – typically measured by the standard deviation of returns. But volatility is an inappropriate measure of risk, valid only if markets are efficient – which of course is the very hypothesis under investigation. Besides, many track records do show less, not more than market volatility. So there is only one last, desperate resort: attribute them to dumb luck. With so many investors trying – so the argument runs – some are fated to fall in the right tail of the return distribution.
Such is the status of the Efficient Market Theory that even very smart people get ensnared into this fallacy. Let’s see if they buy this: with so many people trying to run fast, Usain Bolt is just the luckiest freak.
The dominance of the EMT paradigm has very serious consequences. It encourages the view that investing is just a game of chance, where discernment and skills are irrelevant smokescreens. As a result, valuable, insightful investment manuals, like the one recently written by my friend John Mihaljevic, are regarded with suspicion, a bit like manuals of homeopathy or chiropractice – alluring but ultimately deceptive.
The attitude is: never mind all those practitioners quoted in the book, dispensing smart-sounding advice (disclosure: I am one of them). None of it really works. As even Daniel Kahneman puts it, they are all under the Illusion of Validity. And if their track records seems to show the opposite, it is just a matter of luck: sooner or later, they will inexorably revert to the mean.
Such is the sorry state of investment theory under the hegemony of the EMT. Rather than by The Intelligent Investor, The Margin of Safety or The Manual of Ideas, the educated view is moulded by the doctrines of Cardinal Fama and his enclaves. But – as witnessed by Bob Shiller sharing the Nobel Prize – Galileo’s voice is getting louder.
