Jul 252014

In one of his few video recordings (see below, at 14:05), Ben Graham was asked: Are Wall Street professionals usually more accurate in their near or long term forecasts of stock market trends? If not, why not?

Surprisingly at first, his answer sounded like an endorsement of the Efficient Market Theory:

Well, we’ve been following that interesting question for a generation or more, and I must say frankly that our studies indicate that you have your choice between tossing coins and taking the consensus of expert opinion, and the results suggest about the same in each case. Your question as to why they are not more dependable is a very good one and an interesting one. And my own explanation for that is this: that everybody on Wall Street is so smart that their brilliance offsets each other, and that whatever they know is already reflected in the level of stock prices pretty much, and consequently what happens in the future represents what they don’t know.

The answer has two parts. The first is: the consensus of expert opinion is as accurate as a coin toss. This is Mr Market: the price is always right, i.e. the coin is fair, hence there is a 50% chance that the price goes up (Head) and a 50% chance that it goes down (Tail). Mr Market is a perfectly calibrated but totally worthless expert. As Seth Klarman puts it: Mr Market knows nothing.

How does this square with the second part of Graham’s answer? Graham says: Wall Street experts do know, but whatever they know is already reflected in current prices, and whatever they don’t know at present, but will know in the future, will be reflected in future prices.

A late conversion to the EMT? No. Here is what Graham had to say on the subject shortly before his death:

Question: By some coincidence as you were becoming less active as a writer, a number of professors started to work on the random walk theory. What do you think about this?

Answer: Well, I am sure they are all very hard working and serious. It’s hard for me to find a good connection between what they do and practical investment results. In fact, they say that the market is efficient in the sense that there is no particular point in getting more information than people already have. That might be true, but the idea of saying that the fact that information is so widely spread that the resulting prices are logical prices – that is all wrong. I don’t see how you can say that prices made in Wall Street are the right prices in any intelligent definition of what right prices would be. (An Hour with Mr. Graham, p. 38).

What Mr Market knows is known knowns. As such, these are reflected in current prices – in this sense the EMT is correct. But, crucially, this doesn’t make those prices right. Mr Market does not know the right price – this is the sense of Klarman’s quip. The EMT is wrong: current prices are not the same as right prices.

What Mr Market fails to notice is an unknown known: the price level, which, subject to the Prior Indifference Fallacy – it takes as a given. Mistaking Mr Market for an accurate expert, who knows the right price, leads investors to miss the best and safest investment opportunities. Investors should instead heed Mr Graham: rather than trying to predict where the price will go tomorrow, they are better off thinking where it should be today.

By the way, Through chances various, through all vicissitudes, we make our way…, the epigraph to The Intelligent Investor, is not from Horace (at 4:50 on the video) but from Virgil’s Aeneid:

Per varios casus, per tot discrimina rerum, tendimus in Latium
Book I, 204-5



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