The battle over just how efficient the market is and how to define risk has been overdone for several decades. I think most people have come to their senses or have, at least, accepted that markets aren’t nearly as efficient as was once preached.
Still, it’s always nice to know that not everyone back in the day fell for a theory that assumed we were all rational beings. That somehow we can make emotional decisions throughout our daily lives but the second our thoughts turn towards investing and money, we shut it off entirely and only act rationally. Seriously, how far-fetched is that?
Had more people stopped to think about it for a few seconds, they might have saved the blogosphere vasts amounts of time and energy on an argument that refuses to die.
As Graham lays out, the market sometimes lacks common sense and gets emotional with the information it has.
First, here’s Graham’s take on beta versus risk (emphasis mine):
So far I have been talking about the virtues of the value approach as if I had never heard of such newer discoveries as “the random walk”, “the efficient market”, “efficient portfolios”, the Beta coefficient, and other such. I have heard about them, and I want to talk first for a moment about Beta. This is a more or luess useful measure of past price fluctuations of common stocks. What bothers me is that authorities no equate the Beta idea wit hthe concept of “risk.” Price variability yes; risk no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management… The idea of measuring investment risks by price fluctuations is repugnant to me, for the very reason that it confuses what the stock market says with what actually happens to the owners’ stake in the business.
His views on “efficient markets”:
Let me shorten slightly the definition of an efficient market that appears on p. 97 of The Stock Market by Lorie and Hamilton. “An efficient market is one in which a large number of buyers and sellers cause the prices to reflect fully what is knowable about the prospects for the companies dealt in.” The key phrase for me is “reflect fully.” Let us assume first that it means only that the market has and uses all knowable information about every company’s prospects, and hence that there is no point for analysts to spend their time trying to obtain additional information. I dissent for that statement to the extent that it would render meaningless the current controversy and concern on the use of “material information”, particularly as obtained by security analysts from managements. If in all cases the market already knows and reflects all that is knowable about each enterprise then there should be no such thing as “material inside information.”
But that is not my chief quarrel with the concept of the “efficient market.” There is a strong implication in the Lorie and Hamilton book that because the market reflects fully all the knowable facts it thereby establishes correct or reasonably correct prices for common stocks. Hence, only the superior security analyst can successfully select the stocks that should be bought or sold. These exceptional people — in the authors’ words — “have a quicker and more profound understanding of the economic consequences to individual firms of changes in the economic environment or changes within the firm itself.” They have “a rare and valuable talent.” I disagree competely with this view. To establish the right price for a stock the market must have adequate information, but it by no means follows that if the market has this information it will thereupon establish the right price. The market’s evaluation of the same data can vary over a wide range, dependent on bullish enthusiasm, concentrated speculative interest and similar influence, or bearish disillusionment. Knowledge is only one ingredient on arriving at a stock’s proper price. The other ingredient, fully as important is sound judgement. Take Avon Products, which sold at 140 early last year, or $8 billion for the company and under 20 — or mere $1.2 billion — last month. Was the market for Avon “efficient” on both these dates, in the same sense that the price reflected “fully and properly” (the latter my addition to the Lorie and Hamilton phrase) the knowable facts. Were the changes in the short period in the environment or the company’s prospects sufficient to cut 85 percent from the true value of this highly profitable, well-managed, and strongly financed enterprise?
That at the other extreme the large group of stocks selling for less than their working capital. Is the market “efficient” in maintaining these “fire-sale” price levels? Surely it does not lack the essential information about companies. What it does lack is judgement, courage and patience.
Source:
The Renaissance of Value – Ben Graham ’74
Related Reading:
Stocks Can Fluctuate Widely in a Year
Ben Graham’s Built-in Destabilizer of Markets
