Ideas Have Consequences

The right wing has poisoned the minds of finance people and business managers for just over a generation. The lies taught have destroyed the economy. That is the message in a posting by John Mauldin at Barry Ritholtz's The Big Picture web site:

The Efficient Market Hypothesis, according to Shiller, is one of the most remarkable errors in the history of economic thought. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brainwashing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH - pretty much everyone’s hand was up. Then he asked how many of them believed it. Only two hands stayed up!

And we wonder why funds and banks, full of the best and brightest, have made such a mess of things. Part of the reason is that we have taught economic nonsense to two generations of students. They have come to rely upon models based on assumptions that are absurd on their face. And then they are shocked when the markets deliver them a “hundred-year flood” every 4 years. The models say this should not happen. But do they abandon their models? No, they use them to convince regulators that things should not be changed all that much. And who can argue with a model that was the basis for a Nobel Prize?

...

Ideas have consequences, and bad ideas usually have bad consequences. The current maelstrom from which we are emerging (finally, if in fits and starts) has many culprits. A lot of bad ideas and poor management that came together to create the perfect storm. Today, we look at some of the ideas that are part of the problem but are too often glossed over because they are “academic” and not of the real world. However, gentle reader, academic ideas that are taught and accepted as gospel by 99% of the professors have real-world consequences.


...

The EMH supporters have strong similarities with the Jesuit astronomers of the 17th Century who desperately wanted to maintain the assumption that the Sun revolved around the Earth. The reason for this desire to protect the maintained hypothesis was simple. If the Sun didn’t revolve around the Earth, then the Bible’s tale of Joshua asking God to make the Sun stand still in the sky was a lie. A bible that lies even once can’t be the inerrant foundation for faith!

The efficient market hypothesis (EMH) has done massive amounts of damage to our industry. But before I explore some errors embedded within the approach and the havoc that they have wreaked, I would like to say a few words on why the EMH exists at all.

You need to go read the whole article to get all the juicy details.

Here's why it is important to put a stake through the heart of the EMH (Efficient Markets Hypothesis):

To be honest I wouldn’t really care if EMH was just some academic artefact. The real damage unleashed by the EMH stems from the fact that as Keynes long ago noted “practical men… are usually the slaves of some defunct economist”.

And, sadly Mauldin points out that investors never really learn from their mistakes:

The EMH, as Shiller puts it, is “one of the most remarkable errors in the history of economic thought”. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brain washing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH - pretty much everyone’s hand was up. Then he asked how many of them believed in it….only two hands remained up!

A similar sentiment seems to have been expressed by the recent CFA UK survey which revealed that 67% of respondents thought that the market failed to behave rationally. When a journalist asked me what I thought of this, I simply said “About bloody time”. However, 76% said that behavioural finance wasn’t yet sufficiently robust to replace modern portfolio theory (MPT) as the basis of investment thought. This is, of course, utter nonsense. Successful investors existed long before EMH and MPT. Indeed, the vast majority of successful long-term investors are value investors who reject pretty much all the precepts of EMH and MPT.

Will we ever be successful at finally killing off the EMH? I am a pessimist. As Jeremy Grantham said when asked what investors would learn from this crisis: “In the short term, a lot. In the medium term, a little. In the long term, nothing at all. That is the historical precedent”. Or as JK Galbraith put it, markets are characterised by “Extreme brevity of financial memory… There can be few fields of human endeavour in which history counts for so little as in the world of finance”.

Watch for the next post where I take material from the Mauldin article and post it separately. It is a classic bit of behavioural economics showing the limits of "expertise" in the real world.