The Most Destructive Theory in Modern Finance

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Much of what is taught in school about investing is theoretical nonsense. There are few rich professors.

Worse, there are financial theories originating from our best schools that lead to destructive outcomes, wreaking havoc on the economy and global financial markets. The Long-Term Capital Management blowup in 1998 was, at its core, a problem of overreliance on academic theories. The 2008 Wall Street meltdown was caused in part by an overreliance on mathematical models that promised investors such a calamity could never happen.

This is dangerous stuff. It's like Yogi Berra said: "In theory there is no difference between theory and practice. In practice there is."

Last month I asked Robert Arnott, CEO of Research Affiliates, what he thought was the most popular idea in modern finance that was totally wrong. Here's what he had to say (transcript follows):

Morgan Housel: What do you think is the most popular theory in investing that is totally wrong?

Robert Arnott: That's an easy one. The most destructive theory in finance today, and for the last 50 years, has been efficient-market hypothesis. Warren Buffet put it well when he said, what could be more advantageous than to deal with a trading partner who was trained not to think?

The notion that markets are efficient is intuitively wrongheaded. It's very difficult to prove that markets are materially inefficient, because you've got a lot of people thinking and gauging valuations and vying for who's right, so prices frequently are reasonably close to fair. Once in a while, they become extravagantly removed from fair -- Nortel and Cisco in the year 2000, that kind of thing.

But the efficient-market hypothesis, I think, has done a lot of damage. It was advanced because in a rational world where people have similar information, in a world in which people use that information wisely, prices should be correct. It ignores human nature. It also has the merit of being very roughly, very crudely and approximately true, but it's the gap between market efficiency in the real world where the profit opportunities lie, and that world is driven by human emotion and crowd behavior."


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  • Report this Comment On January 14, 2013, at 10:51 PM, prginww wrote:

    Thanks again for the transcript...because I NEVER use the videos. This article and Arnott's commentary has the merit of being at once obvious and profound. Just like the efficient market myth...ha! However, fool that I am (just had to get that in) I note that events DISPROVE the efficient market theory daily. Particularly when current events send stocks like DDD or F or TIE on 5 or 10 or 50% excursions in a matter of days. If they were worth that a few days later, they were worth that a few days earlier, but the market did not price it in.... so it cant be very efficient....

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