48 ATaleofTwoMarkets
show that market behavior is far more complex than EMT allows.
While that is bad news for market efficiency, it is good news for
investors who recognize reality.
EMT may remain valuable to economists in explaining portions
of market processes—the public capital markets alternately may in-
volve both random and nonrandom components. But this partial va-
lidity must not be misunderstood to suggest that markets are “rela-
tively efficient,” “reasonably efficient,” “sufficiently efficient,” or
“more efficient than not” at any moment in time, as many devotees
of EMT have been forced to argue since the market crash of 1987
shoo kconfidence in that theory.
Since 1987, a new generation of economists has arisen in prom-
inent universities to challenge EMT. Led by Robert Shiller of Yale,
a school of thought called behavioral finance draws on a wide range
of disciplines—including economics, psychology, biology, demogra-
phy, sociology, and history—to challenge the essentially mathemat-
ical underpinnings of EMT.
The pioneers of behavioral finance have found substantial evi-
dence supporting two of Buffett’s long-held and most commonsense
propositions. The first is that while stoc kprices over short horizons
bounce around a lot, wedging price and value, over long horizons
the price must correspond to value. As Andrei Shleifer of Harvard
puts it, summarizing the studies: “Stocks with very high valuations
relative to their assets or earnings (growth or glamour stocks), which
tend to be stocks of companies with extremely high earnings growth
over the previous several years, earn relatively low ris kadjusted re-
turns in the future, whereas stocks with low valuations (value stocks)
earn relatively high returns.”^10
The second is evidence showing that investing in the latter group
of stocks (mislabeled “value stocks,” but the label is useful to sim-
plify the discussion) offers superior returns over long horizons. How-
ever measured, the evidence Shleifer and his colleagues compiled
shows that “value” stocks outperform “growth” stocks by spreads of
about 8 to 10% annually over long horizons.
As early as 1981, Shiller showed that stoc kmar ket prices are too
volatile to accord with EMT. Shiller’s peers at that time skewered
him for this blasphemy, but his research has held up and attracted
a still small but growing following, including former Harvard pro-
fessor Lawrence Summers, who became secretary of the treasury.
Shiller examined the relationship between price changes and sub-
sequent cash paid to stockholders and found remarkable irregularity