ProzacMarket 27and cannot be sure that investor sentiment will not change adversely
at any time.^14
Evidence of the noisy investor approach to the stoc kmar ket in-
cludes following tips or acting on rumors, rapidly turning over one’s
portfolio, selling good performers while retaining bad ones (thus trig-
gering taxable gains rather than generating tax-deductible losses),
paying huge mutual fund fees for poor managerial performance, and
imitating others in running off market cliffs by using silly technical
trading strategies.
The causes of this behavior remain poorly understood, but psy-
chological research suggests a number of tendencies. These tenden-
cies include attitudes toward ris kthat lead people to be more averse
to loss than eager for gain; this explains the irrational tendency to
hold losing stocks while selling winning stocks. Another is skewing
the probabilities of uncertain future events by basing forecasts on
past patterns, such as by forecasting that earnings growth over the
next ten years will equal that of the last three.
In theory, smart money arbitrageurs could correct all these errors
and profit from them, keeping EMT intact. But this is a risky busi-
ness. If there is mispricing today, there may be mispricing tomorrow.
If stocks are highly priced compared to value, an arbitrageur will sell
short and await the correction. But the correction may not arrive
before she has to cover. If stocks are lowly priced compared to value,
an arb will buy and await the rise. But that correction could take a
long time, during which those funds could be deployed at higher
returns elsewhere.
Another possibility is that individual actions that are rational can
produce aggregate results that are irrational. This happens all the
time in business. After air-conditioning was invented, for example,
retail stores spent substantial sums to install it, but once every store
did this, none of them enjoyed any competitive advantage as a result.
It is why you see a gas station at every corner of a suburban inter-
section. Buffett gives the example of what occurs when each person
watching a parade decides he or she can see a little better by stand-
ing on tiptoe.
Despite these profound insights developed at the frontiers of
thought about how markets work, they continue to be treated by
many leading economists as variations on the theme. Maybe there
is some deviation in EMT, its devotees admit, but the deviations are
due to mere chance. Eugene Fama, for example, continues to argue
that apparent overreaction to information is just as common as ap-