How to Think Like Benjamin Graham and Invest Like Warren Buffett

51

Chapter4. Amplified Volatility

T

he efficient market story and the chaotic market story are neither

exhaustive nor mutually exclusive accounts of market behavior.

Rather, they depict end points on a continuum ranging from perfect

pricing to substantial deviation between price and value. These polar

points at the outer ranges of the continuum are a function of the

amount of price volatility. Price volatility can move prices toward

values (and is efficient) but can also push prices away from values

(and is inefficient).

Measuring how much market behavior is captured by the effi-

ciency story or the chaos story is hard. But if a generous estimate is

that EMT has explained about 80% of stoc kmar ket behavior in the

past couple of decades, an important question is how much it is

likely to explain in the future. To answer that question, we need to

thin kabout the sources of volatility in pricing and assess whether

those sources are trending toward greater efficiency or greater price-

value discrepancies.

The sources of volatility that lead prices to part from fundamental

values are (1) the quality of information used by market participants in

trading, (2) the complexity of the markets in which trades are effected,

and (3) the discipline of market participants. A good prognosis is that

with the rise of on-line and computer-based trading and the spread of

fountains of noisy information all through the Internet, day and min-

ute traders will drive market mania to an ever more acute state of bi-

polar disorder. Chaos rather than efficiency seems ascendant.

INFORMATION VOLATILITY

The first source of stoc kmar ket volatility relates to information

changes. Information volatility has both a positive (efficient) dimen-

sion and a negative (inefficient) dimension.

Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use