How to Think Like Benjamin Graham and Invest Like Warren Buffett

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Chapter3. Chaotic Market

T

oday’s investor can learn something from the elite group of No-

bel Prize winners who brought us the “modern finance” sum-

marized in the last chapter, but way less than is commonly believed.

Although few informed students of EMT ever had great confidence

in the strong form, the more modest forms—plus modern portfolio

theory and beta (β)—have held sway over academic and popular

investment thinking for nearly three decades.

Those hypotheses are based exclusively on simple linear analysis

and thought, however, and so their descriptive power and normative

implications are questionable. As in all fields of endeavor, knowledge

continues to advance. Technology has enabled better ways to model

market behavior than were available when EMT and the rest of mod-

ern finance were growing up. The new technology shows quite dif-

ferent results than did the old, results that confirm the common-

sense intuitions behind Ben Graham’s Mr. Market.^1

NEW WAVE

The presence of noise in stoc kmar ket trading shows the inadequacy

of the linear testing models that led to the random wal kmodel and

EMT. Noise theory shows that the information-processing properties

of public capital markets are so bluntly powerful that fundamental

information about underlying business values is crowded out by ex-

traneous information or noise. There is a feedbac ksystem in which

individuals overreact to information or withhold action in the face

of information.

Feedbac kprocesses are the hallmar ks of a nonlinear system.

They indicate a nonproportional relationship between a cause and

its effect (e.g., between news and price changes). This insight of

noise theory has not been recognized for its full power. The distinc-

tion between linear and nonlinear is fundamental to an understand-

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