My wife Jacqueline got her MBA from the University of Chicago, where the efficient market hypothesis (EMH) was religion. EMH says that in the long run, no one can beat the stock market because it is too efficient. An investor might beat the market for a year, or maybe several years, but that’s just luck.
This was the standard view at Chicago during Jacqueline’s time there, and it was well supported by data: The long-term performance of professional fund managers against market indexes was notoriously poor.
But there was always the standard challenge, “What about Warren Buffett?”
That challenge had its own standard reply: If you have enough investors, somebody like Buffett is inevitable—just like if you have enough people flipping coins, you’ll get someone who tosses twenty heads in a row.
It made sense at the time. However, this year Jacqueline was surprised to read about a debate held in 1984—well before her time at Chicago—that pitted an EMH advocate, University of Rochester Professor Michael Jensen, versus Buffett. The episode is recounted in Sebatian Mallaby’s More Money Than God.
Jensen presented the standard argument that Buffett was a random fluke. In response, Buffett continued Jensen’s line of thinking. He said that if 225 million people (then roughly the population of the United States) were in a coin-flipping contest to get the most heads in a row, 215 people should achieve 20 heads in a row by chance. Buffett then said that if those 215 people were randomly distributed, he would agree that chance was merely at work. But if a significant number of those people all had something rare in common—say, a specific coin-flipping technique—that would be a different situation. As Mallaby summarizes, “If you found that a rare cancer was common in a particular village, you would not put that down to chance. You would analyze the water.”
Buffett went on to argue that the few investors who beat the market over the long term were not randomly distributed. As evidence, he cited nine fund mangers, including himself, whose value-investing strategies descended from those of investor Ben Graham. As Mallaby writes:
Buffett insisted that he had not cherry-picked his examples; he was reporting the results of all Graham-Newman alumni for whom there were records and all the fund managers whom he had won over to the value-investing method. Without any exceptions, and without copying one another’s stock choices, each of Ben Graham’s heirs had beaten the market. Could this be simple fortune?
Buffett later converted his debate comments into an article, which has its own Wikipedia page. The page is perhaps most notable for its “Rebuttals” section, which suggests that academia has ignored, rather than rebutted, Buffett’s argument: “A 2004 search of 23,000 papers on economics revealed only 20 references to any publication by Buffett.”
Of course, EMH is about a model. A model can be wrong in some respects but right (or at least useful) in many other ways. Buffett’s challenge may have exposed some wrongness in EMH, as have more recent critiques from behavioral and complexity economics. Moreover, the financial crisis that started in 2007 further undermined EMH as a safe assumption. But a widely accepted, “less wrong” alternative to EMH has not emerged.
What has emerged is a questioning of standard views. Such questioning always existed—even at Chicago—in rarefied theory classes. But I suspect today’s equivalents of Jacqueline’s MBA classes have a little less of Jensen’s perspective and a little more of Buffett’s skepticism.