Why the Apparatchiki of Finance Didn’t See It Coming

Originally posted on 3/7/2009 by Patrick Byrne

I know a great joke. Unfortunately, I’ve learned that some people don’t get it without a preface.

So here’s the preface: In the 1950’s there was a school of psychology called “Behaviorism”. Behaviorists turned away from the “internal states” that had been the concern of psychology since its inception, regarding them as mental constructs whose explanation invoked unscientific mysticism. Behaviorists instead proposed a new “scientific” paradigm and mission: to describe “the organism” in terms of inputs to and outputs from a Black Box whose inner workings need not be explained. If you have seen 1950’s grainy black-and-white films of BF Skinner teaching pigeons to spin around and peck buttons, and chickens learning to perform simple tasks, you have seen Behaviorism in action.

So here’s the joke: Two professors of behaviorist psychology have sex. When they’re finished they light up cigarettes. One says to the other, “So…. That was good for you. How was it for me?”

It’s a great joke. For those who still missed it, the point is that the professors were so wrapped up in their theory (in this case, the denial of internal states), that they could not experience what was right in front of them. They had to filter their data through the theory to which they were committed before they could experience it.

Sometimes such commitments bind their holders so strongly they forget that what they are committed to are just paradigms. For example, Richard Feynman told a story about how, in 1895, the chairman of the Harvard Physics Department discouraged new graduate students from starting PhD’s on the grounds that all the questions of physics had been answered, with the exception of two problems. Those two problems were the photoelectric effect and the problem of black-body radiation. Their subsequent investigation spawned quantum mechanics, shattering the classical Newtonian paradigm to which the Harvard department chair had been committed.

Modern finance theory is dominated by two pillars: the “Capital Asset Pricing Model” (or “CAPM”) and “Efficient Market Theory” (or “EMT”). CAPM is a model that says, Market participants will bid the price of a financial asset up and down until its return and its volatility satisfy a certain equilibrium equation. Efficient Market Theory evolves alongside of CAPM to say, Prices have already been so bid to reflect all publicly available information.

An implication of Efficient Market Theory is that, since securities are already priced to reflect all publicly available information, it is impossible to beat the market without having inside information. While for some years the leading edge of finance theory has been nibbling away at EMT, it is no exaggeration to say that it is still the dominant paradigm of modern finance, and that every MBA program in American universities teaches EMT as the core of finance theory.

By happy accident I was exposed to EMT by its greatest counterexample, Warren Buffett. I was 14 when he impressed upon me the ridiculousness of EMT. He loved the fact that it was taught in business schools, he said, for it made his job “like playing bridge with people who have been told it doesn’t help to look at the cards.” Later, I was fortunate also to know Dr. Kenneth Arrow (one of the founders of general equilibrium theory, and the originator of Arrow’s Impossibility Theorem, a tidy social choice proof he did over a weekend when he was 26 for which he later won the Nobel Prize). Dr. Arrow also ridiculed Efficient Market Theory, saying, “Believing in EMT is like believing you can’t find a $20 bill in the street because if it were there someone else would have picked it up already.”

Mr. Buffett and Dr. Arrow warned me about the intense dogmatic belief in Efficient Market Theory among finance professors. Mr. Buffett compared their profession to a Mayan priesthood whose practitioners had invested years in learning the arcane language of their priest craft (or as he put it with regard to finance professors, “had gotten their Ph.D.’s learning how to talk to each other in Greek letters”). He pointed out how natural it was for priests to defend the hard-won skills which set them apart from ordinary mortals.

Mr. Buffett has beat the market so handily, for so many years, that his success is an affront to Efficient Market Theory. Naive EMT proponents at first discounted Buffett’s success: give enough chimpanzees coins to flip, and one of them is going to get 10 heads in a row, they said. This led to Buffett’s famed response, “The Superinvestors of Graham-and-Doddsville“, first delivered in a talk at Columbia University, and then reprinted as an Appendix to The Intelligent Investor.

Buffett’s partner, Charles Munger, has had this to say on the subject:

Now let’s talk about efficient market theory, a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact one of the economists who won — he shared a Nobel Prize — and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn’t quite as efficient as you think, he said, ‘Well, it’s a two-sigma event.’ And then he said we were a three-sigma event. And then he said we were a four-sigma event. And he finally got up to six sigmas — better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter] ….
“…what made these economists love the efficient market theory is the math was so elegant. And after all, math was what they’d learned to do. To the man with a hammer, every problem tends to look pretty much like a nail…

Finance professors and economists have missed the boat on stock manipulation schemes such as naked short selling because they are confined by the straight-jacket of their theory to the point that they cannot experience what is right in front of them. When confronted with data showing the existence of naked short selling, they answer that any manipulative effects are impossible. Their addiction to EMT locks them into a worldview that maintains, There is an ocean of capital out there ready to pour in and correct any mispricing, so mispricing cannot exist. This worldview prevents them from understanding the effects of stock manipulation schemes such as naked short selling.

I will give some recent examples of this (because I do not care to embarrass any individuals I will not identify anyone by name):

     • Not long ago a sitting commissioner of the SEC made precisely this argument in private: CAPM tells us it should not matter how many shares are trading in the market, phantom or otherwise, as long as the market knows how many have been issued;

     • Along the same lines, the current internal party line of the SEC’s Office of Economic Analysis is that anyone objecting to naked short selling must also object to short selling, because within legal short selling shares could theoretically be sold-lent-sold-lent, thus creating an infinite number of shares. This objection misses the boat on two counts: the practical constraints of the settlement system would prevent such an infinite chain from developing (and if it did, we might in fact have to reconsider our commitment to the benefits of short selling); besides which, the short seller pays for his position, and by paying that price he injects valuable information into the marketplace, whereas the naked short selling skips paying that price and hence the information he injects into the marketplace is value-less;

     • As recently as last June, a high official within the SEC’s OEA was arguing internally that there is no difference between naked shorting and writing a futures contract. He was correct in that a naked short position is akin to a derivative called a “Contract For Difference”. He was wrong in that a naked short position creates a futures contract that is in some sense involuntary, cheats the buyer of rights he thinks he is acquiring (such as the right to vote shares), and has the unusual feature of being able to affect the underlying value of which its value is putatively derivative (a producer of orange juice may write derivative contracts on how much the sun will shine in Florida all he wants, and it will not affect the underlying event, but if I sop up all demand for a thinly-traded small cap company by diverting it into what are in effect CFD’s, the underlying event, that is, the stock price, will be affected).

My point is not to descend too far into the arcana of such debates. Instead, it is to suggest that modern finance theoreticians have become misguided because they reason from a foundation of Efficient Market Theory.

A couple of years ago I visited a United States Senator who walked me through arguments the hedge fund’s lobbyists had recently rehearsed to him, arguments holding that, in effect, everything I claimed was going on in the market was theoretically impossible. I said to him, “Sir, they can line up finance professors from here to MIT who say this is impossible. I can line up tough Italian guys from here to Staten Island that say they do it every day.”

Like Newtonian physics, which gives good results on much scale of interest to humans, EMT is useful. It may even be directionally correct, expressing a powerful marketplace dynamic. However, there are corner cases it gets hopelessly wrong. Sadly, over time those corner cases have become a non-negligible corner of the market. And as this has happened the finance professoriate, unable to see what was right in front of its eyes, has stayed busily asking itself, “That was good for you, how was it for me?”