Investment Theory: More Multidisciplinary Thinking Needed

Published on September 29, 2009

Every time a major financial crisis occurs, numerous premature obituaries of the Efficient Market Theory (EMT) seem to appear in various business publications.  The Wikipedia link provided here only offers a cursory explanation of the theory but is a useful introduction for those who have not been indoctrinated through academic courses.

While the EMT is often ridiculed as being obviously false, academics have attempted to adjust the theory over the years and it is now very rare to encounter anyone who believes in the strong-form version of the theory.  Most academics believe in the semi strong-form of the theory which states that all publicly available information regarding a firm’s prospects must be reflected in the stock price.  The weak-form hypothesis, which implies that technical analysis is of no value, is widely accepted by most security analysts including many value investors.

New Models Required

The Financial Times is running a series on “The Future of Investing” this week.  An article this morning outlines the need for new models to address deficiencies in the EMT and predicts that such models will not come anywhere close to the mathematical elegance of the EMT.

If the theory needs to be abandoned, the effect on investing will be profound.  More important still is what will come to replace it.  Efficient markets borrowed from mathematics but that is now widely regarded as an oversimplified and often downright misleading theory that fostered the cavalier confidence leading to the crash.

Academics are now ransacking a range of other disciplines in the quest for a better understanding.  That search has ranged from evolutionary biology through behavioral psychology to thermal dynamics and chaos theory.  None is likely to deliver answers as clean and simple as those that came from efficient markets.

The idea of “ransacking” a range of other disciplines to promote better decision making in business and investing is not new.  Berkshire Hathaway Vice-Chairman Charlie Munger is widely credited with coming up with this concept and has been giving lectures on the topic for several years.  Readers of Poor Charlie’s Almanack have access to many of Mr. Munger’s lectures on this subject.

Dangers of False Precision

It seems very clear that new models from a variety of disciplines are required to come up with more robust theories for investing.  The danger will be that academics may attempt to come up with theories that offer a false level of precision.  Jeremy Grantham was quoted in the Financial Times article warning against this tendency:

Mr. Grantham suggests that the entire efficient markets framework should be jettisoned.  Economists keep the idea, he says, because they are “incapable of dealing with theories that don’t give answers to two decimal points, and the only kind of theory that can deliver that is one based in complete rationality.”

The Financial Times article goes into more detail regarding several concepts and alternative models including adaptive and behavioral theories intended to explain market movements that are not adequately addressed by the EMT.  None of these models offer the mathematical elegance of the EMT, but they may have the virtue of being more grounded in reality.

History of Premature Obituaries

It is not as if the events of the past two years represent the first deviation from the predictions of the Efficient Market Theory.  Over the past quarter century, we have experienced the 1987  stock market crash, the 1989 “mini crash”, the 1997 Asian financial crisis, and the dot com boom and bust of the late 1990s.  All of these events were inadequately explained by the EMT, yet mainstream academic thinking did not seem to quickly adapt.  This time may be no different.

Investment Theory: More Multidisciplinary Thinking Needed