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YOU’RE DRIVING DOWN the highway when, all of a sudden, a maniac goes speeding by, weaving in and out of lanes. Most of us have experienced this—and most of us have the same reaction. “That guy is crazy,” we think to ourselves. “If he doesn’t slow down, someone’s going to get hurt.”
But suppose that an observer instead responded, “That fellow’s speed is perfectly appropriate. Nothing at all wrong with it.” Now, you might think it’s the observer who’s the crazy one.
That, in a nutshell, describes the viewpoint of Eugene Fama, a finance professor who won the Nobel Memorial Prize in Economics for his work developing a concept known as the efficient market hypothesis (EMH). If you aren’t familiar with EMH, it postulates that stock prices are rational because they reflect all publicly available information about the underlying company.
Supporters of EMH like to point to the case of the Challenger Space Shuttle. In 1986, it suffered a catastrophic failure shortly after launch that killed all seven crew members. Almost instantaneously, investors somehow figured out which of the companies that had worked on the Challenger was most likely at fault—and drove down its stock price. After a monthslong investigation, investors’ instantaneous judgment was proven correct. To EMH adherents, this is a picture-perfect illustration of why, in their view, stock prices accurately reflect each company’s value at any given moment.
And this is why Fama is skeptical of stock market bubbles. He allows that sometimes investors make mistakes and the price of isolated stocks get out of whack. But Fama rejects the idea that the broad stock market can ever be characterized as too high. That’s because he believes so strongly in informational efficiency and investor rationality.
Now age 81, Fama continues to defend this view, despite the rise of behavioral finance, which argues that stock prices are driven by human beings, who are sometimes rational but—more often than not—very emotional. Fama, in fact, goes as far as to say, “There is no such thing as behavioral finance. Essentially, it’s just a criticism of efficient markets.” In his rejection of the human element in driving stock prices, Fama is a little bit like the ancients who—despite mounting evidence—believed that the Earth was flat.
Who am I to criticize one of the best-known people in finance, a winner of academia’s most prestigious prize? The reason I’m so critical is precisely because of his status in the investment world. I believe it’s irresponsible to say stock prices are always rational—and not to urge caution when caution is warranted. In Fama’s words, “Almost all investors should regard markets as efficient for their own investment decisions.” He continues with this declarative statement, “If they do that, they will be better off in the long term.”
In other words, Fama is saying, don’t worry about the price you pay for an investment because it is, by definition, correct. In my view, this is just crazy. Consider a few examples from 2020:
In other words, broad segments of the market have become unhinged from reality. This isn’t a new phenomenon. Individual stocks, and sometimes the entire market, can get carried away. Despite Fama’s assertion that prices are rational, the reality is that markets are often driven by stories, momentum, greed, fear, euphoria—and, among those late to the party, a fear of missing out.
Fama’s view is that, if they even exist, bubbles can only be recognized with the benefit of hindsight. He derides those who even attempt to spot bubbles: “Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them.”
I’m the first to say that market forecasting is difficult. But I also think that’s a little too glib. When you see things that look like market excesses, I would recommend this more balanced approach:
1. Stand clear. Fear of missing out is a powerful force, and it’s exacerbated when the media runs stories like the one about Brandon Smith, who became a millionaire by plowing his entire life’s savings into Tesla.
2. Stay the course. I don’t recommend jumping on the Tesla bandwagon—but I would be equally careful of going to the other extreme. If today’s market has you worried, avoid the temptation to sell—or to sell everything. Instead, just take the opportunity to judiciously rebalance back to your asset allocation targets.
3. Don’t overstay the party. If you own one of this year’s hot investments and are now sitting on big profits, that’s great. But I wouldn’t do what Brandon Smith is doing, which is to stay 100% invested in Tesla. Instead, I’d develop a framework for selling so that these gains don’t slip through your fingers. You could, for example, sell half of your shares now, then sell more on a fixed schedule—once a month, for example. Or you could tie the size of your sales to the share price, selling more as the price rises. But whatever you do, don’t take Fama’s word as gospel. If a stock’s price looks too good to be true, it probably is.
Adam M. Grossman’s previous articles include Help Today’s Self, Split the Difference and Game Theory. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.
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I switched from stocks to bonds in 1999 and 2008. November 2020 went to 15% stocks. Why play when you already won.
These all strike me as elements of risk management. Taken as a whole, these thoughts provide a useful framework for looking at how much risk you are taking in your portfolio.
At first glance, many choices look like a gamble – do I roll the dice, or fold? I try to reframe the question to ask how much risk should a long term investor be taking and what kinds of risk. Once I decide on an answer, an appropriate rebalance will generally allow me reset my risk to my pre-determined comfort level. I hope so anyways. I’ve mentioned before that I have a limited level of trust market statistics generally, and that includes risk statistics in particular.
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Apple’s was not off at all. The improvement in the competence of the company, the execution improvements and the huge bomb that M1 has been have reasons for the higher valuation.
You’re right of course, but I think the matter goes deeper than efficiency, the stock price drivers are not rational. https://humbledollar.com/2020/10/a-seat-at-the-slots/
Maybe the drivers are rational. 🙂
Rational (adj.) late 14c., “pertaining to reason.” Reason (n.) c. 1200, “intellectual faculty that adopts actions to ends.”
Maybe they are behaving rationally with efficiently distributed data that many people then pollute in the emotion of fear and greed, thus generating great short-term differences between Price and Value. Garbage-in, garbage-out, but rationally processed.*
I think the two great combatants of Price and Value would closely agree if we were all computers.
I think, over the long-term, the emotional noise largely cancels and markets as a whole tell the truth, whether we agree with it or not.
* An example from Where Are The Customer’s Yachts?, written in 1940, concerned the Price and Value of US Steel. The author easily reported its Price from the morning’s paper, but then mentioned that its Value was much, much less because war was on the horizon! Or maybe the Value was much, much more because war was on the horizon! 🙂
I think market valuations are pretty rational when actual profits, and current interest rates, are taken into account. They may legitimately fluctuate a lot in the near future, but I don’t think they’re irrational.