A Random Walk Through The Rubble


I was still trying to reconcile the monetarist and Keynesian perspectives when Charles P. Kindleberger, professor of economics emeritus at MIT and the author of a well-regarded book entitled Manias, Panics, and Crashes , offered his thoughts on the subject in The New York Times . “Neither monetarism nor Keynesianism is much help in understanding either the 1929 or the 1987 crash,” Professor Kindleberger writes. “Investor psychology is to blame.” In his book he offers an account of the onset of the Depression that focuses on “instability of credit and fragility of the banking system”—factors that have, in his view, “unaccountably slipped into disrepute” during the monetarist-Keynesian debate.

At this point the intelligent layman decided he had had enough. If these economists are so smart, 1 thought, how come they can’t even agree about what caused the Depression?

Another question bothered me even more. It was a question about the efficient-market theory, which is my absolute favorite of all the fancy theories that 1 learned in business school.

According to one of its chief proponents. Burton G. Malkiel, the former dean of the Yale School of Organization and Management, the basic idea of efficient-market theory is that “securities markets are very efficient in digesting information.” When information arises that affects a company’s prospects, stock prices immediately adjust to the news. “Thus, it is useless to try to use either technical analysis (an analysis of past price patterns in an attempt to divine the future) or fundamental analysis (an analysis of a particular company’s earnings, its future prospects, etc.…) to attempt to beat the market.”

If these economists are so smart, I thought, why can’t they even agree about what caused the Depression?

The efficient-market theory implies that the price movements of stocks will be highly erratic, like a “random walk” (which is to say, like the sequence of outcomes in a series of coin tossings). Erratic movement follows from the assumption that prices incorporate all known or predictable events. Only unpredictable events matter, and they must occur randomly or else we could predict them.

This may not sound especially exciting, but it leads directly to the conclusion that, as Malkiel puts it, “a blindfolded chimpanzee throwing darts at The Wall Street Journal could pick a portfolio of stocks that would perform as well as those carefully selected by the highest priced security analysts.” The mathematics gets a little complicated, but the basic point is that all those brilliant analysts neutralize one another.

Do the actual movements of stock prices over time move randomly? You bet they do. What about that blindfolded chimpanzee? Well, a blindfolded chimpanzee throwing darts would give you the equivalent of an unmanaged portfolio. And study after study has shown that an unmanaged portfolio that mirrors a broadly diversified stock index will outperform the managed portfolio of the average pension fund or mutual fund.

I love efficient-market theory, and I truly believe that investing in an unmanaged “index” fund, with minimal management and brokerage fees, makes more sense than most of the clever things that people do with their money. But a one-day decline of 508 points in the Dow-Jones industrial average raises a serious question in my mind. Efficient-market theory implies that just before the Stock Exchange opened on Monday. October 19, the thirty stocks in the Dow-Jones industrial average were efficiently and rationally priced at 2,246 and that at the end of the same day, those same stocks were efficiently and rationally priced at 1,738. How could that be? Any rational observer can see that it’s crazy.

“Nothing is more suicidal.” John Maynard Keynes wrote, “than a rational investment policy in an irrational world.” Keynes was a famously successful investor who spent half an hour in bed each morning making stock selections. His trick was to guess where the crowd was going before the crowd itself knew—or, as he put it, “to guess better than the crowd how the crowd will behave.”

It’s not as easy as it sounds. After getting burned in one panic, Sir Isaac Newton commented. “I can calculate the motions of heavenly bodies, but not the madness of people.” Markets and the madness of people—I’ll write about that another time. Meanwhile. I would like to hear from anyone who can restore my faith in the efficient-market theory. And my wife would like to hear from anyone who can answer a simple question: Should we buy or sell, and when?