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Friday, March 6, 2009

"A Theory So Stupid Only an Expert Could Believe It" ?

Brett Arends has a great column in the WSJ entitled

Has Fear Blinded Investors to Value?
Meet the evil twin of the efficient market hypothesis: Efficient market hypnosis

You should read the whole article. I love this quote

The "efficient market hypothesis" used to claim that, when it came to the stock market, "the price was always right" – in other words if, say, ", Inc." was trading at $180 a share, then by golly, that's what it should be trading at, and who could possibly say it was overvalued?

If you think that's a pretty silly line of thinking, you're right. But many people in finance really did believe it, including some otherwise intelligent ones - dotcom mania and all.

It was something so stupid only an expert could believe it.

That theory may be pretty much dead today. But we are all at risk – and I include myself – from its insidious evil twin: Efficient market hypnosis.

This is where the market simply lulls us into submission by constant repetition. You can't fight the tape. If a perfectly good stock has fallen 40% in value, then, by golly, efficient market hypnosis makes us think there must be an excellent reason for it.

Anyone minded to accept the verdict of the stock market should remember that it was at work a couple of years ago in exactly the opposite direction. Lots of people – and I was not immune – were lulled by the overpowering force of the tape upwards

Arends is right ... "only an expert could believe it."

but he is certainly wrong that "That theory may be pretty much dead today." Because it is taught in every finance class in the world and the competing approaches of behavioral economics are far in the minority among academic "experts".
The NYT makes this clear in its article about academic economists

... prominent economics professors say their academic discipline isn’t shifting nearly as much as some people might think. Free market theory, mathematical models and hostility to government regulation still reign in most economics departments at colleges and universities around the country. True, some new approaches have been explored in recent years, particularly by behavioral economists who argue that human psychology is a crucial element in economic decision making. But the belief that people make rational economic decisions and the market automatically adjusts to respond to them still prevails.

The University of Chicago is considered the birthplace and bastion of the efficient market hypothesis. Although Prof Richard Thaler (pictured above) a prominent behavioral economist has breached the walls of the University I don't think he has convinced many of his colleagues to shake their views.

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