Investing Knowledge

Suppose I told you that there's a leading academic theory that is so self-evidently wrong that even my 9-year-old son, when it was explained to him the first time, said, "But that's stupid," and presented several solid objections.

And after decades of research debunking the theory -- so much research, in fact, that a whole new academic discipline rose up around it -- we still hear arguments for the theory from people who should know better.

We even still hear people arguing that the theory's originator should win the Nobel Prize for his efforts.

What's the theory? Markets are rational. Put another way: You can't beat the market.

Rational Markets? Seriously?

Properly speaking, the theory is called the Efficient Market Hypothesis, and what it says is essentially this: Financial markets are "informationally efficient," meaning that prices on traded assets already reflect all known information, and instantly change to reflect new information.

It certainly seems reasonable to say that; most of the time, most share prices move -- pretty much instantly -- in response to news.

But "most of the time" and "most shares" aren't enough to justify what the theory's proponents famously argue: That it's impossible to consistently outperform the market, unless luck (or insider trading) is working in your favour.

So Warren Buffett, Peter Lynch, Anthony Bolton and countless Fools, all of whom outperform the major market indices year in and year out, are just "lucky"?

You know what I'm going to say: Not so much.

The Little Detail The Ivory-tower Crowd Missed

I could spend pages and pages going through all of the problems with the efficient-markets idea. As I said above, a whole new academic discipline -- behavioural finance -- has grown up around research into the problems with the theory. Simply put, behavioural finance is the study of how people actually make decisions involving money.

Long story short, a lot of those decisions aren't rational.

It turns out we're hard-wired to buy high and sell low. We get attached to our first impressions and give too much weight to evidence that seems to confirm them.

We get carried away by the opinions of others in a sort of "herd mentality." We value some types money more than others -- hard-earned money over "found money," for example. We fear losses much more than we crave gains, and we have a compelling need to believe that lost money -- "sunk cost" -- counts for something.

In other words, the little detail that the theory missed is human nature.

Building A Superior Brain

These tendencies can be overcome, of course, with education and practice. That's a big part of what we try to do at the Fool. But these tendencies of human nature are what drive clearly irrational market phenomena like bubbles and crashes and stocks running wild on rumours, or sometimes on nothing at all.

Some hard-core theorists would say that in a world of perfect information, bubbles and crashes would occur only when rational ideas justify them. But it sure didn't look like a rational event during the first few days of March, when the shares below -- and hundreds of others like them plunged faster than Liverpool's league position:

It certainly wasn't rational information-processing that drove all of these shares to these low prices, and to significantly higher prices since. It's not as if BT, Tesco and Marks & Spencer all had sudden adverse changes to their businesses. It's not even that there were rational reasons to believe that economic conditions had suddenly become much more dire.

Mass Panic

What there was, was panic. Fear-driven selling. Irrational decision-making.

Human nature, in other words. Those who saw what was happening and bought during those dark days have made a lot of money since. Not because of rational analysis of fundamentals, but because of a rational recognition of others' irrationality.

If you think about it, that's actually the cornerstone of value investing; the process of finding shares that are undervalued for reasons that aren't sound, and waiting until others catch on and drive prices upward.

The market is often efficient, more or less, in the long run. But there are plenty of times when it isn't -- and those are times when the smart investor can take advantage.

Do that often enough, and you'll beat the market.

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> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who doesn't have an interest in any of the companies mentioned in this article.