The Efficient Market Theory for you

When an upsetting piece of news comes down the pike—the efficient market theory—a trader strains his mind, soul, and entire being trying to pull profits out of the market. Academics, who are fond of pointing out that prices represent all available market information, are its biggest advocates. People buy and sell based on what they know, and the most recent price reflects everything that is known about that market. This is a reasonable point, and the efficient market gang comes to the strange conclusion that no one can beat the market. They claim that the markets know everything, and that trading is like to playing chess versus someone who knows more than you. Don’t squander time or money by indexing your portfolio and picking stocks based on volatility.

What about money-making traders? Winners, according to efficient market theorists, are simply fortunate. The majority of people gain money at some point before reinvesting it in the markets. What about investors who consistently exceed the market year after year? Warren Buffett, one of the greatest investors of the twentieth century, compares investing in a market where people believe in efficiency to playing poker against those who believe it is pointless to look at cards.

I think that the efficient market theory offers one of the truest views of the markets. I also believe it is one of the largest pieces of theoretical garbage. The theory correctly observes that markets reflect the intelli­gence of all crowd members; it is fatally flawed in assuming that investors and traders are rational human beings who always strive to maximize gains and minimize losses. That is a very idealized view of human nature.

Most traders can be rational on a fine weekend when the markets are closed. They calmly study their charts and decide what to buy and sell, where to take profits, and when to cut losses. When the markets open on Monday, the best laid plans of mice and men get ripped up in the sweaty palms of traders.

Trading and investing are partly rational and partly emotional. People often act on an impulse even if they harm themselves in the process of doing so. A winning gambler brags about his positions and misses sell signals. A fearful trader beaten up by the market becomes cautious beyond measure. As soon as his stock ticks down a bit, he sells, violat­ing his own rules. When that stock rises, overshooting his original profit target, he can no longer stand the pain of missing the rally and buys way above his planned entry point. The stock stalls and slides, and he watches, first with hope and later frozen in horror, as it sinks like a rock. In the end, he can’t take any more pain and sells out at a loss—right near the bottom. What’s so rational about this process? The original plan to buy may have been rational, but implementing it created an emotional storm.

Emotional traders do not pursue their best long-term interests. They are too busy savoring the adrenaline rush or too twisted in fear, des­perate to extract their fingers from a mousetrap. Prices reflect intelli­gent behavior of rational investors and traders, but they also reflect screaming mass hysteria. The more active the market, the more traders are emotional. Rational individuals can become a minority, surrounded by those with sweaty palms, pounding hearts, and clouded minds.

Markets are more efficient during flat trading ranges, when people are apt to use their heads. They grow less efficient during trends, when people become more emotional. It is hard to make money in flat mar­kets because your opponents are relatively calm. Rational people make dangerous enemies. It is easier to take money from traders who are excited by a fast-moving trend because emotional behavior is more primitive and easier to predict. To be a successful trader you must keep your cool at all times and take money from aroused amateurs.

People are more likely to be rational when alone, and grow more impulsive when they join crowds. A trader’s intense focus on the price of a stock, a currency, or a future pulls him into the crowd of all who trade that vehicle. As the price ticks up and down, the eyes, the heads, and the bodies of traders across the continents start moving up and down in unison. The market hypnotizes traders like a magician hyp­notizes a snake, by moving his flute rhythmically up and down. The faster the price moves, the stronger the emotions. The more emotional a market, the less efficient it is, and inefficiency creates profit oppor­tunities for calm, disciplined traders.

A rational trader can make money by remaining calm and following his rules. Around him, the crowd chases rallies, hard with greed. It sells into falling markets, squealing from pain and fear. All the while, the intelligent trader follows his rules. He may use a mechanical system or act as a discretionary trader, reading his markets and putting on trades. Either way, he follows his rules rather than his gut—that is his great advantage. A mature trader pulls money through the big hole in the efficient market theory, its presumption that investors and traders are rational human beings. Most people aren’t; only winners are.