Searching for Rational Investors In a Perfect Storm by Louis Lowenstein


In October, 1991, there occurred off the coast of Massachusetts a “perfect storm,” a tempest created by a rare coincidence of events. In the late ‘90s, there was another perfect storm, an also rare coincidence of forces which caused huge waves in our financial markets, as the NASDAQ index soared, collapsed, and bounced part way back.

What had happened to the so-called “rational investors”, the smart money, whom economists have for decades said would keep market prices in close touch with the underlying values? Despite the hundreds of papers on markets and their efficiency, it is a remarkable fact that no scholar, not one, has looked to see who are these rational, i.e., value, investors, how they operate, and with what results.

I decided to see how a group of ten value funds, selected by a knowledgeable manager, performed in the turbulent boom–crash–rebound years of 1999-2003. Did they suffer the
permanent loss of capital of so many who invested in the telecom, media and tech stocks? How did their overall performance for the five years compare with the returns on the S&P 500? For most managers, mimicking the index, it was difficult not to own Enron, Oracle and the like, but the ten value funds had stayed far away. Instead, they owned highly selective portfolios, mostly 34 stocks or less, vs. the 160 in the average equity fund. Reflecting their consistent and disciplined approach, they turned their portfolios at one-sixth the rate of the average fund. Bottom line: every one of the ten outperformed the index over the five year period, and as a group they did so by an average of 11% per year, the financial equivalent of back-to-back no-hitters.

The article closes with a discussion of the clearly large implications for investors, market watchers and public policy. As for those economic models, let the chips fall where they will.

Searching for Rational Investors In a Perfect Storm – introduction

In October 1991, there occurred off the coast of Massachusetts a “perfect storm,” a tempest created by a rare combination of events, primarily an Arctic cold front colliding with a hurricane, that would create waves 30 meters high and of course wreak havoc and death among the fishermen caught in its path.1 In the late ‘90s, there was another perfect storm, a rare coincidence of forces which created such turbulence in our financial markets that stock prices were distorted out of all relationship to their normal patterns. Like that nor’easter, there were huge costs to the innocents caught in its grip.

The speculative excesses of the ‘90s threw a harsh light on efficient market theory (EMT), which for decades has been a cornerstone of economic theory and scholarship.2 No BSchool student has escaped it; no economics professor has won tenure without paying his respects. EMT has also had significant impact on public policy and investment practices. It is, indeed, an appealingly simple idea, that in order to make money in the stock market one must compete against the “smart money,” the so-called rational investors, who are constantly scouring the market for opportunities. Because of them, all relevant new information is quickly captured by the market. No point in doing research oneself. Trust prices; the rational investors will already have erased most any discrepancy between price and value.3 Since you cannot beat the market, buy a diversified portfolio, say the Standard & Poor’s 500 index fund, and save yourself the cost and sweat of an actively traded account.

Obviously the theory was wrong – woefully so. In the late 1990s, stocks soared to levels out of all proportion to their underlying values, indeed to levels well beyond even the excesses of the 1920s.4 If the NASDAQ Composite Index, for example was right at 1200 in April 1997, it surely wasn’t right at 5000 in March 2000, and then right again at 1100 two years later. (The rise and then almost 50% decline of the broader based S&P 500, though widely noted, was also stunning.

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