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A “rational” stock market? More like a “drunken psycho”

February 2, 2015
A “rational” stock market? More like a “drunken psycho”

Long before sector bubbles and flash crashes, academics, professional traders, and Saturday-morning financial quarterbacks touted the underlying “wisdom” of the markets as if they were clones of Ward Cleaver in Leave it to Beaver.

Under the long-established “efficient market” hypothesis, stocks and bonds carried a you-can’t-touch-this veneer. The rational market theory claims that you can never beat the markets, because share prices incorporate all pertinent information and adjust almost instantly.

In other words, stocks always trade according to their fair value, not necessarily what traditional fundamentals or technical analysis might dictate.

Let’s say a candy company trading at $100 a share launches a new sweet that promises to melt pounds away like an M&M in your mouth—and push the stock up by $25. The rationalists might want you to believe that once the news breaks, the stock price will jump to $125 then and there. All pertinent information is out, and the market adjusts immediately.

This theory held sway for decades, with academics proffering deep-dive studies to support it and then teaching it to packs of future Wall Street brokers and traders. Even former Federal Reserve Chairman Alan Greenspan’s mid-’90s warning of “irrational exuberance”—watch out, excess investor enthusiasm will pop that bubble!—didn’t put a dent in the theory’s credibility.

That’s not to say there weren’t naysayers. Warren Buffett, for example, never bought into it. Buffett’s philosophy, honed from Benjamin Graham’s teachings on value investing, basically boils down to “buy low, sell high,” but with a twist on picking up stocks when their “intrinsic” value is bottoming (Intrinsic value is based on the firm’s qualitative and quantitative aspects, which are not always reflected in the market value of the stock).

Enter Volatility

The markets go up and the markets go down, but rational markets ebb and flow neatly. At least, until 2008, which is around the time when volatility, so to speak, shed its underground status and went mainstream.

During 2008, the Dow swung 300-plus points up or down in 40 of the year’s 250 trading days. In early October of that year, the Dow plunged 1,874 points, only to recover 936 the following Monday, then drop 733 two days later as the financial crisis roiled the globe. Such experiences surely prompt many investors to wonder if the markets make any sense whatsoever.

Buffett, as many know, has a way with words. In a recent interview with Quicken Loans, he quipped that “Mr. Market is kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused ... you sell to him, and if he gets depressed, you buy from him. There’s no moral taint attached to that.”

Nor does there appear to be much rationality.

Amid the market swings of the past couple decades, new hypotheses took shape that emphasized the human touch of what we now refer to as “behavioral finance.” It’s the recognition that humans are emotional—and yes, sometimes irrational—beings.

Knowing that, and remembering that markets are ultimately represented by humans buying and selling with other humans (algorithms aside), the next time someone tries to tell you about “rational” markets, at least one of your eyebrows should rise.

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