Brendan: Hey Fools, I'm Brendan Byrnes and I'm joined by author Jack Schwager, author of Market Sense and Nonsense. Jack, first of all, thank you so much for joining us.
Jack: Oh, it's great to be here. Thanks.
Brendan: It's really an excellent book. What you do is expose a lot of these investment misconceptions, one of which is the efficient market hypothesis, which you call the "deficient market" hypothesis.
Could you talk about that, and talk about why this is so widely taught if it's ... you do a great job of proving it wrong.
Jack: Right, right. It's so widely taught for the same reason. I use an example that may be a little bit of a cliché, but the drunk who drops his car keys at night, then looks under the lamp post because that's the only place there's light, not because he necessarily remembers dropping them there.
The efficient market hypothesis proponents use it as a cornerstone of financial theory because, if you make that assumption -- that the market's always right and everything's priced in and prices are randomly distributed -- you can quantify everything.
You can quantify what has more risk, supposedly; you can do portfolio optimization. It makes the math come out. You can measure risk, supposedly.
Even though the theory isn't correct in practice, it makes it easy to calculate an answer. It may not be the right answer, but you can get an answer.
Brendan: Can you give me, maybe, one specific that proves this wrong? You go over several in the book.
Jack: Oh, yeah. I don't know how to pick my favorite, but just take ... I don't have to go back to October '87 – there's millions of them – but the October '87 is the most amazing one, perhaps, because the market was down 29% in one day.
If market prices are always right, and that assumption goes with prices being normally distributed, the probability of getting a 29% drop in one day is such a small number, the only way I can do it is in an analogy.
It would be the probability of picking an atom -- one atom in the whole visible universe -- and then randomly selecting another atom, and picking the exact same atom. If you can believe that, then you can believe the efficient market hypothesis.
