Contents
Stock Market Crushes
Markets Are More Than Simply Irrational—They Can Be Mean
Photographic Evidence: Scientific Evidence of Sentiment Predicting Stock Price Changes
Some People Get Rich by Selling High and Buying Low
Photographic Evidence: Predicting Coin Flips
A Hypothesis Masquerading as a Theory
Sell the Fads, Buy the Outcasts
An Instinct for Losing Money
During the war of 1812, the Native American Chief Tecumseh captured the fort of Detroit through an interesting ruse. In the conflict, federal and state troops, under the command of Major-General Hull, vastly outnumbered about 1,000 Native American warriors. Tecumseh had his fighters run out of the woods and then secretly circle back to emerge again. General Hull saw—and counted—the same warriors over and over and was fooled into thinking he faced a vastly larger force. He surrendered without a shot.
In any endeavor it is important to have an accurate estimate of the opposition. General Hull gave up before the fight started because he treated a small force like an army. Similarly, the idea that markets are efficient is at best a hypothesis, which is a weak statement. Investors who surrender to dreams of market efficiency give up before the investing battle has begun.
Proven scientific views of the world are called theories. For example, all of us know that gravity is true, yet it is categorized as a theory. In contrast to proven theories, new ideas that may or may not be true are labeled "hypotheses." Importantly, even those who defend market rationality label their idea as only a hypothesis, acknowledging that it has not been proven.
In fact, the belief in market efficiency might not even qualify for hypothesis status. The great philosopher of science, Sir Karl Popper, writes, "In so far as a scientific statement speaks about reality, it must be falsifiable; and in so far as it is not falsifiable, it does not speak about reality." 20
In order to reach the standard of hypothesis, an idea must be provable, which means that there must potentially be evidence that could disprove it. As we have seen, there is essentially no way to disprove the idea of efficient markets. Popper excludes unfalsifiable ideas as being outside of science, mere dogma.
"Double, double toil and trouble; Fire burn, and cauldron bubble," say the witches in Macbeth, associating bubbles with troubles. However, these same witches also note that in some situations "foul is fair and fair is foul." When someone sells a house to buy a ridiculously expensive tulip bulb, for example, another person gets to buy a house for the rock-bottom price of one tulip bulb.
Investors who accept the dogma of market efficiency give up the opportunities that exist precisely because markets are irrational. Such surrender might be merited if the idea of market efficiency was a proven theory, but it is at best a hypothesis, and at worst a nonscientific assertion.
Why Professors Fly Coach and Market Speculators Own Jets
"I have made my living from market inefficiency," so the financier Alfred Checchi told me during a visit to my Harvard Business School classroom.
In contrast, most of the professors at the Harvard Business School are believers in market efficiency, and one told me (with apparent sincerity) that technology stocks were not overpriced in 2000.
Although Mr. Checchi is frequently invited to visit the Harvard Business School , he is so offended by the assumption of market efficiency that he refuses to attend finance classes. (Similarly, the Nobel Prize- winning economist Professor Ronald Coase told me that his only objection to the idea of "bounded rationality" is that the word "rational" should not be used in any sentence describing human behavior.)
So who has been more successful in finding market opportunity, efficiency-preaching professors or irrationality-exploiting financiers? Alfred Checchi was able to spend $30 million of his own money on a run for governor in California . Furthermore, while professors usually fly on commercial airlines, Alfred Checchi's success not only provided him with enough money to buy a private jet, it even allowed him to buy a substantial stake in Northwest Airlines.
The lesson is that those who seek profit should stop looking for absolute proof that markets are not efficient. Such proof is not possible. In contrast, those who seek superior performance should, like Mr. Checchi, accept market irrationality as the first step toward profit.
Furthermore, Mr. Checchi shows that crazy markets don't have to be mean. They can, in fact, be very nice. The key is to be on the right side of irrationality—to sell at high prices and buy at low prices.