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
Over the last 40 years, Warren Buffett has increased the value of Berkshire Hathaway at a compounded rate of 22.2% per year. Over the same period, the S&P 500 stocks have increased by 10.4% a year; $1,000 invested with Warren Buffett at the start of this period would have been worth $2,594,850 at the end of 2003 versus $47,430 for an equivalent investment in the S&P 500.
So Warren Buffett seems to have a pretty good record of buying and selling at favorable prices—prices that the efficient markets hypothesis suggests should never exist. Furthermore, Warren Buffett seems to have done a lot better than a dart-throwing monkey.
Warren Buffett actively seeks undervalued investments. In his 2003 letter to shareholders he writes:
When valuations are similar, we strongly prefer owning businesses to buying stock or selling stock. During most of our years of operations, however, stocks were much the cheaper choice. We therefore sharply tilted our asset allocation in those years towards equities ... In recent years, however, we've found it hard to find significantly undervalued stocks.
So Warren Buffett believes that undervalued stocks sometimes exist. He also says that there are not many good values in the stock market these days. If the efficient markets hypothesis were true, there would not be any better or worse time to buy stocks; all prices would be fair at all times. So Warren Buffett has made his fortune by acting precisely in a fashion that would be silly if markets were rational.
The Denial: The believers in the efficient markets hypothesis deny that Warren Buffett's success is due to skill. Their argument is as follows: Put 1,024 people in a room. Have each of them flip a coin 10 times. On average, one of them will have produced 10 heads in a row. Now call that person Warren Buffett.
In other words, there are lots of money managers and by sheer dumb luck someone will have a great track record. That great track record, in this view, predicts nothing about the future.