The rational and irrational views of markets make competing predictions in this situation. If the efficient markets hypothesis were true, then nothing would predict the future changes in price. If the market were rational, then the winners portfolio would have the same performance as the losers portfolio.

But, Professors Thaler and DeBondt found that individual stocks exhibit the same pattern as the market as a whole: Pessimism precedes rises, and optimism precedes falls. In their words, Loser portfolios of 35 stocks outperform the market by, on average, 19.6%, thirty six months after portfolio formation. Winner portfolios, on the other hand, earn about 5.0% less than the market. This study was published in the prestigious Journal of Finance.

The winner and loser study contradicts the efficient markets hypothesis, which predicts that memoryless markets dont care about previous performance. Many other behavioral finance studies have produced evidence that contradicts the efficient markets hypothesis. (Professor Thaler collected and published 21 such studies in Advances in Behavioral Finance.17) To which the true believers argue that the studies are contrived and people who trade at irrational prices would be weeded out.

It wasnt me.

Claim #3: Some People Get Rich by Selling High and Buying Low

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 500.18

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 owning stocks. 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 recentyears, however, weve 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 Buffetts 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.

Photographic Evidence: Predicting Coin Flips

If Warren Buffetts success in the past was luck, then the efficient markets hypothesis suggests that for next year he is not expected to outperform the market or a dart-throwing monkey. In this thought experiment the winner who produces 10 heads in a row has exactly a 50% chance

of producing an eleventh head on the next coin flip, the same odds as a loser who produced 10 tails in a row.

Professor Thaler has created a money management firm (run with Russell Fuller) that seeks to systematically exploit irrational market opportunities. The firm makes investment decisions guided by the findings of behavioral finance. Although the firm is young, the results are interesting; as of the end of 2003, the firms six funds are outperforming their benchmarks by an average of 8.1% a year.19 To which the true believers argue that the performance of these funds, like the performance of Warren Buffett, is luck and not skill.

No one can really know if a particular performance is due to skill or luck. However, the interesting point is that the efficient markets hypothesis cannot be proven false by any investors performance. Regardless of how many more good years Warren Buffett or Fuller-Thaler have, defenders of the efficient markets hypothesis can argue that superior performance is sheer luck.

It wasnt me.

A Hypothesis Masquerading as a Theory

During the war of 1812, the Native American Chief Tecumseh captured the fort of Detroit through an interesting ruse. In the conflict, federal and state troops, under the command of Major-General Hull, vastly outnumbered about 1,000 Native American warriors. Tecumseh had his fighters run out of the woods and then secretly circle back to emerge again. General Hull saw-and counted-the same warriors over and over and was fooled into thinking he faced a vastly larger force. He surrendered without a shot.

In any endeavor it is important to have an accurate estimate of the opposition. General Hull gave up before the fight started because he treated a small force like an army. Similarly, the idea that markets are efficient is at best a hypothesis, which is a weak statement. Investors who surrender to dreams of market efficiency give up before the investing battle has begun.