Over the last 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

Source:   Berkshire Hathaway Shareholder Letters

Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.

Source:   Berkshire Hathaway Shareholder Letters

A “flash crash” or some other extreme market fluctuation can’t hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.

Source:   Berkshire Hathaway Shareholder Letters

Thaler pokes fun at much that is holy at the University of Chicago. Indeed, Thaler believes, with me, that people are often massively irrational in ways predicted by psychology that must be taken into account in microeconomics.

Source:   Poor Charlie's Almanack

All the equity investors in total, will surely bear a performance disadvantage per annum equal to the total croupiers’ costs they have jointly elected to bear. This is an inescapable fact of life. And it is also inescapable that exactly half of the investors will get a result below the median result after the croupier’s take, which may well be somewhere between unexciting and lousy.

Source:   Poor Charlie's Almanack

…it's rather interesting because one of the greatest economists in the world is a substantial shareholder in Berkshire Hathaway and has been from the very early days after Buffett was in control. His textbook always taught that the stock market was perfectly efficient and the nobody could beat it. But his own money went into Berkshire and made him wealthy. So, like Pascal in his famous wager, he hedged his bet.

Source:   Poor Charlie's Almanack

Is the stock market so efficient that people can't beat it? Well, the efficient market theory is obviously roughly right - meaning that markets are quite efficient and it's quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way. Indeed the average result has to be the average result. By definition, everybody can't beat the market. As I always say, the iron rule of life is that only twenty percent of the people can be in the top fifth. That's just the way it is. So the answer is that it's partly efficient and partly inefficient. And, by the way, I have a name for people who went to the extreme efficient market theory - which is "bonkers". It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had difficulty in that the fundamental assumption did not tie properly to reality.

Source:  

If you stop to think about it, a pari-mutuel system [like a race-track] is a market. Everybody goes there and bets, and the odds change based on what's bet. That's what happens in the stock market.

Source:   Poor Charlie's Almanack

Of course, the best part of [Benjamin Graham's approach] was his concept of "Mr. Market". Instead of thinking the market was efficient, Graham treated it as a manic-depressive who comes by every day. And some days "Mr. Market" says, "I'll sell you some of my interest for way less than you think is worth." And other days, he comes by and says "I'll buy your interest at a price that's way higher than what you think it's worth." And you get the option of deciding whether you want to buy more, sell part of what you already have, or do nothing at all. To Graham, it was a blessing to be in a business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it's been very useful to Buffett, for instance, over his whole adult lifetime.

Source:   Poor Charlie's Almanack

Well, Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to. I think you'd have to believe in the tooth fairy to believe that you could easily outperform the market by seven percentage points per annum just by investing in high-volatility stocks.

Source:   Poor Charlie's Almanack

Whereas investors are supposed to be open to any asset—and to both owning it and being short—the truth is very different. Most professionals are assigned to particular market niches, as in “I work in the equity department” or “I’m a bond manager.” SETH KLARMAN: Silos are a double-edged sword. A narrow focus leads to potentially superior knowledge. But concentration of effort within rigid boundaries leaves a strong possibility of mispricings outside those borders. Also, if others’ silos are similar to your own, competitive forces will likely drive down returns in spite of superior knowledge within such silos.

Source:   The Most Important Thing

In the great debate over efficiency versus inefficiency, I have concluded that no market is completely one or the other. It’s just a matter of degree. I wholeheartedly appreciate the opportunities that inefficiency can provide, but I also respect the concept of market efficiency, and I believe strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there.

Source:   The Most Important Thing

You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong-enough stomach to defy conventional wisdom (one of the greatest oxymorons) and resist the myth that the market’s always efficient and thus right. You need experience on which to base this resolute behavior. And you must have the support of understanding, patient constituencies. Without enough time to ride out the extremes while waiting for reason to prevail, you’ll become that most typical of market victims: the six-foot-tall man who drowned crossing the stream that was five feet deep on average.

Source:   The Most Important Thing

When buyers compete to put large amounts of capital to work in a market, prices are bid up relative to value, prospective returns shrink, and risk rises. It’s only when buyers predominate relative to sellers that you can have highly overpriced assets. The warning signs shouldn’t be hard to spot.

Source:   The Most Important Thing

The assertion that future outcomes are fully reflected in current expectations seems absurd, yet it is very much alive. It is at the basis of the prevailing paradigm in financial economics. Market prices are seen as passive reflections of the underlying fundamentals. The efficient market hypothesis claims that market prices fully reflect all extant information. The closely related rational expectations theory holds that, in the absence of exogenous shocks, financial markets tend toward an equilibrium that accurately reflects the participants' expectations. Together, these theories support the belief that financial markets, left to their own devices, assure the optimum allocation of resources. This paradigm is in deep trouble: the idea that financial markets tend toward such an equilibrium seems to be contradicted by the evidence. Most economists now recognize that financial markets are capable of producing multiple equilibria. Yet the idea that free, unregulated markets assure the optimum allocation of resources has not been abandoned. Great efforts have gone into reconciling the actual behavior of financial markets with the efficient market hypothesis, adopting ever more elastic definitions of rationality and ever more modest definitions of efficiency. These modifications do not go far enough. It is time for a paradigm shift.

Source:   The Alchemy of Finance

Reflexivity has been strangely neglected in economic theory. By taking the demand-supply curves as given, economic theory can treat market prices as a mere reflection of the underlying fundamentals (i.e. supply) and the participants' preferences (i.e. demand). This leaves out of account the active, creative and distortive effect of the participants' imperfect understanding. It gives a very misleading picture of financial markets. For instance, it implies that investors base their decisions on the fundamentals, whereas the goal of market participants is to make money. Only if market prices reflected the fundamentals accurately would it make sense to be guided by those fundamentals - and in that case, nobody could make more money than anybody else and everyone ought to invest in index funds. This is absurd conclusion yet it is still widely accepted.

Source:   The Alchemy of Finance

In a pure exchange, equilibrium has a clearly defined meaning: it is the price that clears the markets. When it applied to financial markets, equilibrium becomes more like a theological concept: it is the price that ought to clear the markets if market prices did not have any effect on the participants' attitudes and/or the fundamentals. But it is the nature of financial markets that they do have such effects. Consequently financial markets often develop boom/bust sequences and other far-from-equilibrium conditions.

Source:   The Alchemy of Finance

In my investing career I operated on the assumption that all investment theses are flawed…The fact that a thesis is flawed does not mean that we should not invest in it as long as other people believe in it and there is a large group of people left to be convinced. The point was made by John Maynard Keynes when he compared the stock market to a beauty contest where the winner is not the most beautiful contestant but the one whom the greatest number of people consider beautiful.

Source:   The Alchemy of Finance

Existing theories about the behavior of stock prices are remarkably inadequate. They are of so little value to the practitioner that I am not even fully familiar with them. The fact that I could get by without them speaks for itself. Generally theories fall into two categories: fundamentalist and technical. More recently, the random walk theory has come into vogue; this theory holds that the market fully discounts all future developments so that the individual participant's chances of over- or underperforming the market as a whole are even. This line of argument has served as the theoretical justification for the increasing number of institutions that invest their money in index funds. The theory is manifestly false - I have disproved it by consistently outperforming the averages over a period of twelve years. Institutions may be well advised to invest in index funds rather than making specific investment decisions, but the reason to be found is in their substandard performance, not in the impossibility of outperforming the averages.

Source:   The Alchemy of Finance

…I replace the assertion that markets are always right with two others: 1) Markets are always biased in one direction or the other. 2) Markets can influence the events that they anticipate.

Source:   The Alchemy of Finance

...investment fads and misinterpretations of facts may run for several months or several years. In the long run, however, realities not only terminate them, but frequently, for a time, cause the affected stocks to go too far in the opposite direction. The ability to see through some majority opinions to find what facts are really there is a trait that can bring rich rewards in the field of common stocks. It is not easy to develop, however, for the composite opinion of those with whom we associate is a powerful influence upon the minds of us all.

Source:   Common Stocks and Uncommon Profits

If the huge price changes that occur in individual stocks are made solely because of changed appraisals by the financial community, with these appraisals sometimes completely at variance with what is going on in the real world of a company's affairs, what significance have the other three dimensions? Why bother with the expertise of business management, scientific technology, or accounting at all? Why not just depend on psychologists? The answer involves timing. Because of a financial-community appraisal that is at variance with the facts, a stock may sell for a considerable period for much more or much less than it is intrinsically worth. Furthermore, many segments of the financial community have the habit of playing “follow the leader,” particularly when that leader is one of the larger New York City banks. This sometimes means that when an unrealistic appraisal of a stock is already causing it to sell well above what a proper recognition of the facts would justify, the stock may stay at this too high level for a long period of time. Actually, from this already too high a price it may go even higher.

Source:   Common Stocks and Uncommon Profits

The largest profits in the investment field go to those who are capable of correctly zigging when the financial community is zagging...This matter of training oneself not to go with the crowd but to be able to zig when the crowd zags, in my opinion, is one of the most important fundamentals of investment success.

Source:   Common Stocks and Uncommon Profits

In the last few years, too much attention has been paid to a concept that I believe is quite fallacious. I refer to the notion that the market is perfectly efficient. Like other false beliefs in other periods, a contrary view may open up opportunities for the discerning.

Source:   Common Stocks and Uncommon Profits

If the market is efficient in prospect, then the nexus of analysis that leads to this efficiency must be collectively poor.

Source:   Common Stocks and Uncommon Profits

Efficient market theory grew out of the academic School of Random Walkers. These people found that it was difficult to identify technical trading strategies that worked well enough after transactions costs to provide an attractive profit relative to the risks taken. I don't disagree with this. As you have seen, I believe that it is very, very tough to make money with in and out trading based on short-term market forecasts. Perhaps the market is efficient in this narrow sense of the word.

Source:   Common Stocks and Uncommon Profits

Wall Street’s method of using accounting ratios to determine value may capture the here and now but does a woefully poor job of calculating sustainable long-term growth. Or, put differently, more often than not, sustainable long-term growth is mispriced by the market.

Source:   The Warren Buffett Way

To eliminate any notion that the five superinvestors of Buffettville are nothing more than statistical aberrations, we need to examine a wider field. Unfortunately, the population of focus investors is very small. Among the thousands of portfolio managers who manage money, there are only a scant few who manage concentrated portfolios. Thus we are left with the same challenge.

Source:   The Warren Buffett Way

Interestingly, Cremers reports that in 1980, 50 percent of large-cap mutual funds had an active share score of 80 percent or more. That is, half the mutual funds had a portfolio that was significantly different from their benchmark. Today, just 25 percent of mutual funds are considered truly active. “Both investors and fund managers have become more benchmark-aware,” says Cremers. “As a manager, you want to avoid being in the bottom 20% or 40% (of your peer group). The safest way to do that, especially when you’re evaluated over the shorter time periods, is to hug the index.”

Source:   The Warren Buffett Way

The Real Measure of Worth In that famous speech about Graham-and-Doddsville, Warren Buffett said many important things, none more profound than this: “When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”

Source:   The Warren Buffett Way

With stocks held three years, the degree of correlation between stock price and operating earnings ranged from .131 to .360. (A correlation of .360 means that 36 percent of the variance in the price was explained by the variance in earnings.) With stocks held for five years, the correlation ranged from .374 to .599. In the 10-year holding period, the correlation between earnings and stock price increased to a range of .593 to .695. This bears out Buffett’s thesis that, given enough time, the price of a business will align with the company’s economics. He cautions, though, that translation of earnings into share price is both “uneven” and “unpredictable.” Although the relationship between earnings and price strengthens over time, it is not always prescient. “While market values track business values quite well over long periods,” Buffett notes, “in any given year the relationship can gyrate capriciously.” Ben Graham gave us the same lesson: “In the short run the market is a voting machine but in the long run it is a weighing machine.”

Source:   The Warren Buffett Way

Warren Buffett’s approach to investing, thinking of stocks as businesses and managing a focus portfolio, is directly at odds with the financial theories taught to thousands of business students each and every year. Collectively, this financial framework is known as modern portfolio theory. As we will discover, this theory of investing was built not by business owners but by ivory tower academicians. And it is an intellectual house that Buffett refuses to reside in. Those who follow Buffett’s principles will quickly find themselves emotionally and psychologically disconnected from how a majority of investors behave.

Source:   The Warren Buffett Way

Buffett’s problem with the efficient market theory rests on one central point: It makes no provision for investors who analyze all the available information and gain a competitive advantage by doing so. “Observing correctly that the market is frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.”...Nonetheless, the efficient market theory is still religiously taught in business schools, a fact that gives Warren Buffett no end of satisfaction. “Naturally, the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham,” he wryly observed. “In any sort of a contest—financial, mental or physical—it’s an enormous advantage to have opponents who have been taught it’s useless to even try. From a selfish standpoint, we should probably endow chairs to ensure the perpetual teaching of EMT.”

Source:   The Warren Buffett Way

Tucked near the back, on page 424, is my favorite article—“Long-Term Investing.” It first appeared in the May–June 1976 issue of the Financial Analysts Journal. Treynor begins by talking about the ever-present puzzle of market efficiency. Is it true, he wondered, that no matter how hard we try we’ll never be able to find an idea that the market hasn’t already discounted? To address the question, Treynor asks us to distinguish between “two kinds of investment ideas: (a) those whose implications are straightforward and obvious, take relatively little special expertise to evaluate, and consequently travel quickly and (b) those that require reflection, judgment, and special expertise for their evaluation, and consequently travel slowly."“If the market is inefficient,” he concludes, “it will not be inefficient with respect to the first kind of idea, since by definition the first kind is unlikely to be misevaluated by the great mass of investors.” To say this another way, the simple ideas—price-to-earnings ratios, dividend yields, price-to-book ratios, P/E-to-growth ratios, 52-week-low lists, technical charts, and any other elementary ways we can think about a stock—are unlikely to provide easy profits. “If there is any market inefficiency, hence any investment opportunity,” says Treynor, “it will arise with the second kind of investment idea—the kind that travels slowly. The second kind of idea—rather than the obvious, hence quickly discounted insight relating to ‘long-term’ business developments—is the only meaningful basis for long-term investing.”

Source:   The Warren Buffett Way

...the success of some who continually beat the major indexes—most notably Warren Buffett—suggests that the efficient market theory is flawed. Others, Buffett included, argue that the reason most money managers underperform the market is not because it is efficient, but because their methods are faulty.

Source:   The Warren Buffett Way

Economists use the CAPM to test market efficiency, while the CAPM assumes market efficiency. In the words of noted financial economist Richard Roll, any test of CAPM is “really a joint test of CAPM and market efficiency.” Christensen et al. suggest that a number of central concepts in economics should be properly labeled as “constructs” rather than “theories” precisely because they cannot be directly falsified.

Source:   More Than You Know

Changing the nature of the investors changes the nature of the market. If all investors were long-term oriented, the market would suffer a diversity breakdown and hence be less efficient than today’s market.

Source:   More Than You Know

Here’s my main point: markets can still be rational when investors are individually irrational. Sufficient investor diversity is the essential feature in efficient price formation. Provided the decision rules of investors are diverse—even if they are suboptimal—errors tend to cancel out and markets arrive at appropriate prices. Similarly, if these decision rules lose diversity, markets become fragile and susceptible to inefficiency. So the issue is not whether individuals are irrational (they are) but whether they are irrational in the same way at the same time.

Source:   More Than You Know

Given what we know about suboptimal human behavior, the critical question is whether investors are sufficiently diverse to generate efficiency. If you think across multiple dimensions, including information sources, investment approach (technical versus fundamental), investment style (value versus growth), and time horizon (short versus long term), you can see why diversity is generally sufficient for the stock market to function well.

Source:   More Than You Know

One of the best examples of a complex adaptive system—generically, a system that emerges from the interaction of lots of heterogeneous agents—is the stock market. Research suggests that when investors err independently, markets are functionally efficient. What’s more, defining the conditions under which markets are efficient provides us with a template to consider when markets are inefficient.

Source:   More Than You Know

Is there a mechanism that can help explain these episodic lunges? I think so. As I have noted in other essays, markets tend to function well when a sufficient number of diverse investors interact. Conversely, markets tend to become fragile when this diversity breaks down and investors act in a similar way (this can also result from some investors withdrawing). A burgeoning literature on herding addresses this phenomenon. Herding is when many investors make the same choice based on the observations of others, independent of their own knowledge. Information cascades, another good illustration of a self-organized critical system, are closely linked to herding.

Source:   More Than You Know