In the wake of the recent economic turmoil, it has become fashionable to trash the philosophical underpinnings of our financial system. One of the most universally reviled ideas is the Efficient Markets theory:

The efficient market hypothesis—long part of academic folklore but codified in the 1960s at the University of Chicago—has evolved into a powerful myth...The theory holds that the market is always right, and that the decisions of millions of rational investors, all acting on information to outsmart one another, always provide the best judge of a stock’s value. That myth is crumbling.

--The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street By Justin Fox.

It’s not obvious where this idea that “the market is always right” came from exactly, but it’s not part of the Efficient Markets Hypothesis (“EMH”).

Professor Eugene Fama, in a 1970 paper, defined EMH as “the hypothesis that security prices at any point in time ‘fully reflect’ all available information.” “Efficiency” is an abstract concept describing the rapidity and thoroughness with which market prices come to “reflect” (another abstract concept) whatever information is available. In other words, the more completely and instantaneously that market participants use the information they possess, the more “efficient” the market.

EMH, as it is known to finance geeks, seems too esoteric to be worth hating. Yet so do the differences between Sunni and Shiite Islam or Catholicism and Protestantism and lots of people have died over those rather technical differences. It seems that ideas, even very abstract ones, can become doctrine. People are funny that way.

In its most literal form, EMH is actually quite counterintuitive. Under “strong” EMH, for example, it would be impossible for a trader to take advantage of any “mispricings” because they could not, by definition, exist. That is what Fama (et al.) meant when they said that an efficient market fully reflects all information.

It’s easy to understand why economists, mathematicians, and finance theorists found this idea valuable. Like Freud’s Theory of the Unconscious, Darwin’s use of Natural Selection, or Galileo’s demonstration that the sun really is in the center, EMH provided a fresh way to look at the world, opening up an entirely new area of intellectual and philosophical development. However, just like these ideas, time has turned the authors of EMH into saints and their writings into creeds. Ultimately EMH came to be preached, not discussed, leaving little room for doubt or debate. That’s how it was taught to me, too.

The attacks on the EMH are really attacks on the students and teachers of EMH who have risen to power in finance and government. EMH has come to stand in for the arrogance of hedge-fund managers, mortgage brokers, and the risk managers at Lehman, Bear Stearns and AIG. That’s why people bash it: Our brightest finance students just bankrupted the country. Yet, EMH is just an idea, and ideas don’t do much damage by themselves:

It’s ridiculous to blame the financial crisis on the efficient market hypothesis. If you are leveraged 33-1, and you’re holding long-term securities and using short-term indebtedness, and then there’s a run on the bank — which is what happened to Bear Stearns — how can you blame that on efficient market theory?

--Burton Malkiel quoted in Poking Holes in a Theory on Markets by Joe Nocera, June 5, 2009.

Eugene Fama wrote: “Though we shall argue that the model stands up rather well to the data, it is obviously an extreme null hypothesis. And, like any other extreme null hypothesis, we do not expect it to be literally true.” That’s hardly the position of a zealot.

So even if Sigmund Freud never actually said, “sometimes a cigar is just a cigar,” Mark Twain did say, “I smoke in moderation. Only one cigar at a time.”

Eric Wanger, JD, CFA, President of Wanger Investment Management, Inc. and Portfolio Manager, Wanger Long Term Opportunity Fund