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A fortune built on defying the pull of theory

(This article from The Financial Times in 2004 shows how little has changed in the ‘active versus index’ debate in the last decade, but at least we reach the same conclusion).

The efficient market hypothesis is 90% true, and you will lose money by ignoring it. However, judging by Warren Buffett’s fortunes, a few skilled searchers might find rewards in the remaining 10% worth chasing.

You have probably heard the joke about the economist who is walking along the street when his wife points out a $10 bill on the pavement. “Don’t be silly,” he replies, “if there was one, someone would already have picked it up.”

The joke is more illuminating than funny. The economist is, of course, right. There are very few $10 bills on the pavement, for precisely the reasons he identifies. People rarely drop them and when they do the money is quickly picked up. If you see a $10 bill on the pavement, it is probably a piece of litter that looks like a $10 bill. You would not be well advised to try to make a living tramping the streets in search of discarded $10 bills.

The story is intended to mock the commitment of most economists to the efficient market hypothesis – the theory that it is hard to make money by trading because everything there is to know about the value of shares, currencies or bonds is already reflected in the price. A corollary is that share prices follow a random walk – past behaviour gives no guidance as to the direction of future changes, and the next market move is always as likely to be down as up.

Efficient market theory is central to modern financial economics, which has long been the jewel in the crown of the business school curriculum – it combines technical rigour with practical applicability and its successful practitioners command large salaries in financial institutions. In 1978 Michael Jensen, doyen of efficient market theory, famously wrote that “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis”.

So it comes as a shock when the latest rich list from Forbes reveals that Warren Buffett has collected $44 billion by finding $10 bills among the trash on the pavements of Wall Street, and now rivals Bill Gates for the title of the world’s richest man. Mr Buffett’s investment success has long troubled efficient market theorists. He himself noted that if 250 million orang-utans kept flipping coins, one of them would produce a long string of heads. But if the lucky orang-utan keeps tossing heads even after you have picked him out from the crowd, that suggests he knows something you do not.

And so it is with Mr Buffett. In 1999 smart operators thought his luck had run out and sent Berkshire Hathaway shares to a discount on asset value. Mr Buffett eschewed technology shares, explaining that he would not invest in things he did not understand. As usual, he had the last laugh.

Paul Samuelson, who is to economics what Mr Buffett is to investment, published a Proof that Properly Anticipated Prices Fluctuate Randomly, but hedged his bets by investing in Berkshire Hathaway stock. Almar Alchian, a Chicago economist, eager as ever to show that only government regulation gets in the way of market efficiency, attributed Mr Buffett’s success to anomalies in Nebraskan insurance law. But it seems unlikely that these could generate a fortune that is about equal to the entire income of the state.

Advocates of efficient market theory confuse a tendency with a law. As Mr Buffett himself has put it: adherents of the theory, “observing correctly that the market was frequently efficient, went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day”. The joke demonstrates why this must be the case. There is a contradiction at the centre of the efficient market hypothesis. There is no point bending down to pick up a $10 bill because someone will have done it already. But if there is no point in bending down to pick it up, it will still be there. In an article published just after Mr Jensen’s, Joe Stiglitz demonstrated that contradiction, in many lines of mathematics rather than the single line of the stand-up comic, and this was one of the contributions for which he received the Nobel Prize for economics.

But for everyday purposes, it is quite enough to know the story of the $10 bill and its unexpectedly complex interpretation. The efficient market hypothesis is 90 per cent true, and you will lose money by ignoring it. The search for the elusive 10%, like the search for discarded $10 bills, attracts effort greater than the rewards. But for the very few skilled searchers, the rewards can be large indeed.


This article first appeared in The Financial Times on 24 March 2004 and was sourced from John Kay is a long-established British journalist and author.


Harry Chemay
November 08, 2013

I'm not surprised that there has been much feedback on the eternal (or should that be infernal?) debate between proponents of active and passive management. After all there are real dollars (and plenty of them) riding on 'winning' the argument, and so every time the 'active v passive' debate re-emerges battlelines are quickly drawn and steadfastly-held ideologies defended vociferously.

Arguments about the implausibility of the Efficient Market Hypothesis invariably gravitate to considering Warren Buffett. One could however view his track record as the exception that proves the rule. In among the hundreds of thousands of highly intelligent, highly trained and highly paid analysts and money managers in the world, all pouring over the same publically available data and all independently making skillful judgments as to intrinsic value, why, if markets are not highly efficient, is there only one Warren Buffett?

I took a different approach in my article titled 'We're not like Buffett, but we can learn from him' (Cuffelinks Edition 33). His first vehicle, Buffett Partnership, was set up in 1956 as a 'sophisticated investor only' limited partnership. This structure meant that he did not have to file detailed portfolio positions with the US securities regulator, nor limit his holdings to any particular class of securities.

Buffett saw the greatest opportunities not in listed shares, but in unlisted and private companies in which he acquired sizeable positions or took control of outright (Berkshire Hathaway being a case in point). In so doing he was taking on materially different risks to his fellow investment managers who held only listed stocks. Whether these risks were fully compensated for in those early years we may never know. Not without a full record of all his investment decisions pre Berkshire Hathaway listing and some determined number-crunching.

To compute Buffett's annualized risk-adjusted outperformance (alpha) from his Buffett Partnership days onward, one would have to look at each period's return, compare it against that period's corresponding index return and then conduct a regression analysis to determine his alpha. No easy task when Buffett's portfolios over the years haven't readily matched up with commonly available indices at the time.

It is instead easier to look at Buffett's annualized return since inception, compare it with an arbitrary but inappropriate benchmark such as the S&P 500 index, and come to the conclusion that Buffett's track record is proof positive that the Efficient Market Hypothesis is nonsense. Easier, but not necessarily more enlightening.


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