Efficient Market Theory: Let the PunishmentFit the Crime*

You are neither right nor wrong because crowd disagrees with you. You are right because your data and reasoning are right.(1) Beajamin GrahamIn 1980s some things went right on Wall Street but much went wrong. The fallout is still being felt today. Prudential Securities, which for years boasted that the most important thing we earn is your trust, now apologizes for having systematically duped many of hundreds of thousands of investors who bought its limited partnership deals. Carl Icahn boasted of having bought TWA, but leaving none of his own there, he succeeded only in leaving flying public with twenty year-old aircraft and poor service. Banks and insurance companies bankrolled so many new buildings that we will not work off excess until end of century, if then. As we close books on worst era in modern U.S. financial history, Prudential at least has resources to make amends. Those victimized by others must often grasp at straws.This is a good time for a post-mortem. It is not widely recognized, but scholars played an important role in debacle, providing ingenious free-market theories to justify some of worst excesses. One such concept, market theory, contributed to damage then and, in its various mutations, continues to do so today.Even if you are not a student of financial economics, phrase efficient market sounds right. After all, stock market is crudely efficient: markets set minute-to-minute value of stocks, spreads between bid and asked prices are very small, and commissions are as little as two cents a share.Efficient Market Theory (EMT), however, posits something more radical. The principal version, and one on which this indictment will focus, states that we can trust pricing of stocks. Supposedly, competition among sophisticated investors enables stock market to price stocks accurately --that is, in accordance with our best expectations of companies' long-term prospects. (The trading by nonprofessionals is said to be random and of no net effect.) Supposedly, too, all relevant publicly available information is analyzed by investors, and new data, such as releases, are quickly noted, digested, and then reflected in share prices.In short, stock prices, while not perfect, are as perfect as,can be. There are no better estimates of fundamental value of a company and no systems for beating market. A corollary is that wisest of us can do no better than to buy market as a whole; rest of us can do far worse.EMT rests on several quite controversial assumptions, most striking of which is terribly convenient but circular assumption that mispriced stocks cannot long exist because if they did, smart money investors/arbitrageurs would already have eliminated them. This when-all-else-fails assumption, so central to theory, is also source of well-worn joke about two economists walking across campus who spy what seems to be a twenty dollar bill. As younger economist leans forward to examine it, her older colleague restrains her. If it really were a twenty dollar bill, he says, someone would already have picked it up.(2)Given assumption that patience and intelligence are of no consequence, even a super-investor like Warren Buffett should not be able, certainly not with any consistency, to find loose lying on table. In fact, it would be a waste of his time to look.As one of high priests of EMT recently wrote, with visible pride, testing of theory has itself become so voluminous as to be a research industry, and a mature one at that.(3) I do not intend to go over that voluminous, often dreary body of data. Much of it focuses on such trivialities as January effect--small company stocks are said to do better in January--or how quickly market responds to news of, say, a stock split or dividend increase. …