Booms and busts are not symmetrical because, at the inception of a boom, both the volume of credit and the value of the collateral are at a minimum; at the time of the bust, both are maximum. But there is another factor at play. The liquidation of loans takes time; the faster it has to be accomplished, the greater the effect on the value of the collateral...The amazing thing is that the reflexive connection between lending and collateral has not been generally recognized.

Source:   The Alchemy of Finance

Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system. [written in 2002]

Source:   Berkshire Hathaway Shareholder Letters

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.

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

It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed.

Source:   Berkshire Hathaway Shareholder Letters

Both Charlie and I believe that Black-Scholes produces wildly inappropriate values when applied to long-dated options.

Source:   Berkshire Hathaway Shareholder Letters

Part of the appeal of Black-Scholes to auditors and regulators is that it produces a precise number. Charlie and I can’t supply one of those. We believe the true liability of our contracts to be far lower than that calculated by Black-Scholes, but we can’t come up with an exact figure – anymore than we can come up with a precise value for GEICO, BNSF, or for Berkshire Hathaway itself. Our inability to pinpoint a number doesn’t bother us: We would rather be approximately right than precisely wrong.

Source:   Berkshire Hathaway Shareholder Letters

Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination. For that matter, so does the academic’s inclination to dwell on the valuation of options. You can be highly successful as an investor without having the slightest ability to value an option. What students should be learning is how to value a business. That’s what investing is all about.

Source:   Berkshire Hathaway Shareholder Letters

John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it “anomalies.” (I always love explanations of that kind: The Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential, anomaly.)

Source:   Berkshire Hathaway Shareholder Letters

The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.

Source:   Berkshire Hathaway Shareholder Letters

If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.

Source:   Berkshire Hathaway Shareholder Letters

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

Source:   Berkshire Hathaway Shareholder Letters

If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.

Source:   Berkshire Hathaway Shareholder Letters

Beta and Modern Portfolio Theory and the like – none of it makes any sense to me…how can professors spread this? I’ve been waiting for this craziness to end for decades. It’s been dented and it’s still out there.

Source:   Poor Charlie's Almanack

If you think psychology is badly taught in America, you should look at corporate finance. Modern Portfolio Theory? It’s demented! It’s truly amazing.

Source:   Poor Charlie's Almanack

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

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

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

It is true that every established trend has a certain momentum, so that it is more likely to continue for at least a while longer than it is to reverse itself at the moment of observation. But this is far from saying that any trend may be relied upon to continue long enough to create a profit for those who “get aboard”. Rather extensive studies which we have made of the subject lead us to conclude that reversals of trend in every part of the financial picture occur so frequently as to make reliance on a trend a particularly dangerous matter. There must be strong independent reasons for investing money on the expectation of a continuance of past tendencies, and the investor must beware his weighing of future probabilities be unduly influenced by the trend line of the past.

Source:   The Intelligent Investor

Mathematics is principally a tool to meditate, rather than to compute.

Source:   Fooled By Randomness

It is a fact that our brain tends to go for superficial clues when it comes to risk and probability, these clues being largely determined by what emotions they elicit or the ease [with which] they come to mind. In addition to such [a] problem with the perception of risk, its is also a scientific fact, and a shocking one, that both risk detection and risk avoidance are not mediated in the "thinking" part of the brain but largely in the emotional one (the "risk as feelings" theory). The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance. Much of what rational thinking seems to do is rationalize one's actions by fitting some logic to them.

Source:   Fooled By Randomness

When you look at the past, the past will always be deterministic, since only one single observation took place…A mistake is not something to be determined after the fact, but in light of the information until that point. A more vicious effect of [hindsight bias] is that those who are very good at 'predicting' the past will think of themselves as good at predicting the future, and feel confident in their ability to do so.

Source:   Fooled By Randomness

It was confidently believed that the scientific success of the industrial revolution could be carried through into the social sciences, particularly with such movements as Marxism. Pseudoscience came with a collection of idealistic nerds who tried to create a tailor-made society, the epitome of which is the central planner. Economics was the most likely candidate for such a science; you can disguise charlatanism under the weight of equations, and nobody can catch you since there is no such thing as a controlled experiment. Now the spirit of such methods, called "scientism" by its detractors, continued past Marxism, into the discipline of finance as a few technicians thought that mathematical knowledge could lead them to understand markets. The practice of "financial engineering" came along with massive doses of pseudoscience. Practitioners of these methods measure risks, using the tool of past history as an indication of the future. We will just say at this point that the mere possibility of distributions [of data] not being stationary makes the entire concept seem like a costly (perhaps very costly) mistake. [presciently written before the Great Recession of 2008-09]

Source:   Fooled By Randomness

In his 'Treatise on Human Nature', the Scots philosopher David Hume posed the issue [of induction] in the following way: "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute than conclusion".

Source:   Fooled By Randomness

What has gone wrong with the development of economics as a science? Answer: There was a bunch of intelligent people who felt compelled to use mathematics just to tell themselves that they were rigorous in their thinking, that theirs was a science. Someone in a great rush decided to introduce mathematical modeling techniques without considering the fact that either the class of mathematics they were using was too restrictive for the class of problems they were dealing with, or that perhaps they should be aware that the precision of the language of mathematics could lead people to believe that they had solutions when in fact they had solutions when in fact they had none. Indeed the mathematics they dealt with did not work in the real world, possibly because we needed richer classes of processes - and they refused to accept the fact that no mathematics at all was probably better.

Source:   Fooled By Randomness

Our brain is not cut out for non-linearities. People think that if, say, two variables are causally linked, then a steady input in one variable should always yield a result in the other one. Our emotional apparatus is designed for linear causality.

Source:   Fooled By Randomness

According to the academicians who developed capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk...There are many kinds of risk. … But volatility may be the least relevant of them all.

Source:   The Most Important Thing

I’m sure “risk” is—first and foremost—the likelihood of losing money.

Source:   The Most Important Thing

Ben Graham and David Dodd put it this way more than sixty years ago in the second edition of Security Analysis, the bible of value investors: “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.”

Source:   The Most Important Thing

The bottom line is that, looked at prospectively, much of risk is subjective, hidden and unquantifiable.

Source:   The Most Important Thing

Where does that leave us? If the risk of loss can’t be measured, quantified or even observed—and if it’s consigned to subjectivity—how can it be dealt with? Skillful investors can get a sense for the risk present in a given situation. They make that judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value. Other things will enter into their thinking, but most will be subsumed under these two.

Source:   The Most Important Thing

There have been many efforts of late to make risk assessment more scientific. Financial institutions routinely employ quantitative “risk managers” separate from their asset management teams and have adopted computer models such as “value at risk” to measure the risk in a portfolio. But the results produced by these people and their tools will be no better than the inputs they rely on and the judgments they make about how to process the inputs. In my opinion, they’ll never be as good as the best investors’ subjective judgments.

Source:   The Most Important Thing

Bruce [Greenwald] has put it admirably into words: “There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” That’s one of the most important things you can know about investment risk.

Source:   The Most Important Thing

For the most part, I think it’s fair to say that investment performance is what happens when a set of developments—geopolitical, macro-economic, company-level, technical and psychological—collide with an extant portfolio. Many futures are possible, to paraphrase Dimson, but only one future occurs. The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck.

Source:   The Most Important Thing

Projections tend to cluster around historic norms and call for only small changes. … The point is, people usually expect the future to be like the past and underestimate the potential for change.

Source:   The Most Important Thing

The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real.

Source:   The Most Important Thing

Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices.

Source:   The Most Important Thing

Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.

Source:   The Most Important Thing

When things are going well, extrapolation introduces great risk. Whether it’s company profitability, capital availability, price gains, or market liquidity, things that inevitably are bound to regress toward the mean are often counted on to improve forever.

Source:   The Most Important Thing

Investment results will be determined entirely by what happens in the future, and while we may know what will happen much of the time, when things are “normal,” we can’t know much about what will happen at those moments when knowing would make the biggest difference.

Source:   The Most Important Thing

Whatever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate than to deny them and forge ahead. Oh yes; one other thing: the biggest problems tend to arise when investors forget about the difference between probability and outcome—that is, when they forget about the limits on foreknowledge: when they believe the shape of the probability distribution is knowable with certainty (and that they know it), when they assume the most likely outcome is the one that will happen, when they assume the expected result accurately represents the actual result, or perhaps most important, when they ignore the possibility of improbable outcomes.

Source:   The Most Important Thing

Investing in an unknowable future as an agnostic is a daunting prospect, but if foreknowledge is elusive, investing as if you know what’s coming is close to nuts. Maybe Mark Twain put it best: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

Source:   The Most Important Thing

It is an interesting question why such an unrealistic interpretation of financial markets as the efficient market hypothesis should have gained widespread acceptance. The answer is to be found in the requirements of economic theory as a scientific pursuit. Scientific theories are supposed to have some predictive value, and the efficient market hypothesis seems to meet that requirement, while the theory of reflexivity does not.

Source:   The Alchemy of Finance

The achievements of the natural sciences were so impressive that the social sciences sought to imitate them. Not all of the social sciences - for instance, anthropology insists on telling stories rather than establishing universally valid theories - but economic theory in particular has made a valiant effort to imitate natural science.

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

The thinking of the active participant is very different from that of the outside observer. We may call it "organic" as distinct from rational. Scientists are interested in timeless generalizations and statistical probabilities; participants need to focus on the one particular case in which they are participating. Probabilities and generalizations can be useful, but they are misleading if they are based on the viewpoint of the outside observer. That is what happened in economic theory.

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

There seems to be a special affinity between reflexivity and credit. That is hardly surprising: credit depends on expectations; expectations involve bias; hence credit is one of the main avenues the permit bias to play a causal role in the course of events. But there is more to it. Credit seems to be associated with a particular kind of reflexive pattern that is known as boom and bust. The pattern is asymmetrical: the boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic.

Source:   The Alchemy of Finance

If participants labor under the misapprehension that the market is always right, the feedback they get is misleading. Indeed, the belief in efficient markets renders markets more unstable by short-circuiting the corrective process that would occur if participants recognized that markets are always biased. The more the theory of efficient markets is believed, the less efficient the markets become.

Source:   The Alchemy of Finance

My objection to [macro forecasting] is not that it is unreasonable in theory. It is that in the current state of human knowledge about the economics which deal with forecasting future business trends, it is impossible to apply this method in practice. The chances of being right are not good enough to warrant such methods being used as a basis for risking the investment of savings. This may not always be the case. It might not even be the case five or ten years from now. At present, able men are attempting to harness electronic computers to establish “input-output” series of sufficient intricacy that perhaps at some future date it may be possible to know with a fair degree of precision what the coming business trends will be. When, if ever, such developments occur, the art of common stock investment may have to be radically revised. Until they occur, however, I believe that the economics which deal with forecasting business trends may be considered to be about as far along as was the science of chemistry during the days of alchemy in the Middle Ages. In chemistry then, as in business forecasting now, basic principles were just beginning to emerge from a mysterious mass of mumbo-jumbo. However, chemistry had not reached a point where such principles could be safely used as a basis for choosing a course of action.

Source:   Common Stocks and Uncommon Profits

In contrast to guessing which way general business or the stock market may go, he should be able to judge with only a small probability of error what the company into which he wants to buy is going to do in relation to business in general. Therefore he starts off with two advantages. He is making his bet upon something which he knows to be the case, rather than upon something about which he is largely guessing.

Source:   Common Stocks and Uncommon Profits

The fact that a stock has or has not risen in the last several years is of no significance whatsoever in determining whether it should be bought now. What does matter is whether enough improvement has taken place or is likely to take place in the future to justify importantly higher prices than those now prevailing.

Source:   Common Stocks and Uncommon Profits

...many investors will give heavy weight to the per-share earnings of the past five years in trying to decide whether a stock should be bought. To look at the per-share earnings by themselves and give the earnings of four or five years ago any significance is like trying to get useful work from an engine which is unconnected to any device to which that engine's power is supposed to be applied. Just knowing, by itself, that four or five years ago a company's per-share earnings were either four times or a quarter of this year's earnings has almost no significance in indicating whether a particular stock should be bought or sold.

Source:   Common Stocks and Uncommon Profits

The investor is constantly being fed a diet of reports and so-called analyses largely centered around these price figures for the past five years. He should keep in mind that it is the next five years' earnings, not those of the past five years, that now matter to him. One reason he is fed such a diet of back statistics is that if this type of material is put in a report it is not hard to be sure it is correct. If more important matters are gone into, subsequent events may make the report look quite silly. Therefore, there is a strong temptation to fill up as much space as possible with indisputable facts, whether or not the facts are significant. ...many people in the financial community place emphasis on this type of prior years' statistics for a different set of reasons. They seem to be unable to grasp how great can be the change in just a few years' time in the real value of certain types of modern corporations. Therefore they emphasize these past earnings records in a sincere belief that detailed accounting descriptions of what happened last year will give a true picture of what will happen next year.

Source:   Common Stocks and Uncommon Profits

The only true test of whether a stock is “cheap” or “high” is not its current price in relation to some former price, no matter how accustomed we may have become to that former price, but whether the company's fundamentals are significantly more or less favorable than the current financial-community appraisal of that stock.

Source:   Common Stocks and Uncommon Profits

The price of any particular stock at any particular moment is determined by the current financial-community appraisal of the particular company, of the industry it is in, and to some degree of the general level of stock prices. Determining whether at that moment the price of a stock is attractive, unattractive or somewhere in between depends for the most part on the degree these appraisals vary from reality. However, to the extent that the general level of stock prices affects the total picture, it also depends somewhat on correctly estimating coming changes in certain purely financial factors, of which interest rates are by far the most important.

Source:   Common Stocks and Uncommon Profits

Security analysts in those pre-crash days were called statisticians. It was three successive years of sensationally falling stock prices that were to occur just a short time ahead that caused the work of Wall Street's statisticians to fall into such disrepute that the name was changed to security analysts.

Source:   Common Stocks and Uncommon Profits

It is vastly more difficult to forecast what a particular stock is going to do in the next six months. Estimates of short-term performance start with economic estimates of the coming level of general business. Yet the forecasting record of seers predicting changes in the business cycle has generally been abysmal.

Source:   Common Stocks and Uncommon Profits

Buffett thinks the whole idea that price volatility is a measure of risk is nonsense. In his mind, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. “I put a heavy weight on certainty,” he says. “If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing."

Source:   The Warren Buffett Way

We have all heard this mantra of diversification for so long that we have become intellectually numb to its inevitable consequence: mediocre results. Both active and index funds do offer diversification, but, in general, neither strategy will give you exceptional returns.

Source:   The Warren Buffett Way

Lest you think Keynes, with his macroeconomic background, possessed marketing timing skills, take further note of his investment policy. “We have not proved able to take much advantage of a general systematic movement out of and into ordinary shares as a whole at different phases of the trade cycle,” he wrote. “As a result of these experiences I am clear that the idea of a wholesale shift is for various reasons impracticable and indeed undesirable. Most of those who attempt to [do so] sell too late and buy too late, and do both too often, incurring heavy expenses and developing too unsettled and speculative state of mind, which if it is widespread has besides the grave social disadvantage of aggravating the scale of the fluctuations.

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

“Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit has reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?” [says Buffett]

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

Risk, for Buffett, is inextricably linked to an investor’s time horizon. This alone is the single greatest difference between how Warren Buffett thinks about risk and how modern portfolio theory frames risk. If you buy a stock today with the intention of selling it tomorrow, Buffett explains, then you have entered into a risky transaction. The odds are no better than the toss of a coin—you will lose about half the time. However, says Buffett, if you extend your time horizon out to several years, the probability of its being a risky transaction declines meaningfully, assuming of course that you have made a sensible purchase.

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

...you can easily see how applying the Buffett approach will put you in conflict with its proponents. Not only are you intellectually at odds with modern portfolio theorists, but you are also vastly outnumbered, both in the classroom and the workspace. Embracing the Warren Buffett Way makes you a rebel looking out across the field at a much larger army of individuals who invest totally differently. As you will learn, being an outcast has its own emotional challenges.

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

Probabilities alone are insufficient when payoffs are skewed.

Source:   More Than You Know

The frequency of correctness does not matter; it is the magnitude of correctness that matters.

Source:   More Than You Know

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

Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like.

Source:   More Than You Know

While recognition that price-earnings ratios are likely nonstationary is critical, knowing why they are nonstationary provides more practical insight. Three big drivers of price-earnings ratio nonstationarity are the role of taxes and inflation; changes in the composition of the economy; and shifts in the equity-risk premium.

Source:   More Than You Know

Many models in standard finance theory assume that stock price changes are normally distributed around the well-known bell curve. A normal distribution is a powerful analytical tool, because you can specify the distribution with only two variables, the mean and standard deviation. The model, despite its elegance, has a problem: it doesn’t describe real world results very well. In particular, the model is remiss in capturing “fat tails”: infrequent but very large price changes. The failure of risk-management models to fully account for fat tails has led to some high-profile debacles, including the 1998 demise of the hedge fund Long Term Capital Management.

Source:   More Than You Know

Humans have a deep-seated desire to link cause and effect. Unfortunately, markets do not easily satisfy this desire. Unlike some mechanical systems, you can’t understand markets by looking at the parts. Reductionism doesn’t work.

Source:   More Than You Know

[Gary] Gladstein, who has worked closely with Soros for fifteen years, describes his boss as operating in almost mystical terms, tying Soros’s expertise to his ability to visualize the entire world’s money and credit flows. “He has the macro vision of the entire world. He consumes all this information, digests it all, and from there he can come out with his opinion as to how this is going to be sorted out. He’ll look at charts, but most of the information he’s processing is verbal, not statistical.”

Source:   More Than You Know

Much of the real world is controlled as much by the “tails” of distributions as by means or averages: by the exceptional, not the mean; by the catastrophe, not the steady drip; by the very rich, not the “middle class.” We need to free ourselves from “average” thinking. —Philip Anderson, Nobel Prize recipient in physics, “Some Thoughts About Distribution in Economics”

Source:   More Than You Know

In a triumph of modeling convenience over empirical results, finance theory treats price changes as independent, identically distributed variables and generally assumes that the distribution of returns is normal, or lognormal. The virtue of these assumptions is that investors can use probability calculus to understand the distribution’s mean and variance and can therefore anticipate various percentage price changes with statistical accuracy. The good news is that these assumptions are reasonable for the most part. The bad news, as physicist Phil Anderson notes above, is that the tails of the distribution often control the world.

Source:   More Than You Know

The standard model for assessing risk, the capital-asset-pricing model, assumes a linear relationship between risk and reward. In contrast, nonlinearity is endogenous to self-organized critical systems like the stock market. Investors must bear in mind that finance theory stylizes real world data. That the academic and investment communities so frequently talk about events five or more standard deviations from the mean should be a sufficient indication that the widely used statistical measures are inappropriate for the markets.

Source:   More Than You Know

The risk-reducing formulas behind portfolio theory rely on a number of demanding and ultimately unfounded premises. First, they suggest that price changes are statistically independent from one another. . . . The second assumption is that price changes are distributed in a pattern that conforms to a standard bell curve.

Source:   More Than You Know

Do financial data neatly conform to such assumptions? Of course, they never do. —Benoit B. Mandelbrot, “A Multifractal Walk down Wall Street”

Source:   More Than You Know

In an important and fascinating book, Why Stock Markets Crash, geophysicist Didier Sornette argues that stock market distributions comprise two different populations, the body (which you can model with standard theory) and the tail (which relies on completely different mechanisms). Sornette’s analysis of market drawdowns convincingly dismisses the assumption that stock returns are independent, a key pillar of classical finance theory. His work provides fresh and thorough evidence of finance theory’s shortcomings.

Source:   More Than You Know

Complex adaptive systems include governments, many corporations, and capital markets. Efforts to assert top-down control of these systems generally lead to failure, as happened in the former Soviet Union. Thinking about the market as a complex adaptive system is in stark contrast to classical economic and finance theory, which depicts the world in Newtonian terms. Economists treat agents as if they are homogenous and build linear models—supply and demand, risk and reward, price and quantity. None of this, of course, much resembles the real world.

Source:   More Than You Know

The stock market has all of the characteristics of a complex adaptive system. Investors with different investment styles and time horizons (adaptive decision rules) trade with one another (aggregation), and we see fat-tail price distributions (nonlinearity) and imitation (feedback loops). An agent-based approach to understanding markets is gaining broader acceptance. But this better descriptive framework does not offer the neat solutions that the current economic models do.

Source:   More Than You Know

Economists have long understood the role of expectations in shaping economic outcomes, including the performance of the stock market and the robustness of capital spending. Yet most economic models presume rational agents, a convenient modeling assumption that also happens to be safely removed from reality. An agent-based model of markets not only offers results consistent with the empirical facts but also accommodates periodic deviations between price and value.

Source:   More Than You Know

When describing markets, financial economists generally assume a definable tradeoff between risk and reward. Unfortunately, the empirical record defies a simple risk-reward relationship. As Benoit Mandelbrot has argued, failure to explain is caused by failure to describe.

Source:   More Than You Know