That time Buffett smashed the Efficient Market Hypothesis

Warren Buffett’s hero was Ben Graham and with good reason – the lessons of Graham and his writing partner Dodd made Buffett an extraordinarily good investor and a billionaire many times over. Although, to a believer in the Efficient Market Hypothesis, Buffett’s not supposed to even exist – a fact which both Buffett and Charlie Munger derive quite a bit of humor from.

Here’s a great story from thirty years ago, recounted by Samuel Lee at Morningstar

Imagine yourself back in New York City on May 17, 1984. Columbia University is hosting a debate of a kind in celebration of the 50th anniversary of the publication of Benjamin Graham and David Dodd’s classic text “Security Analysis.” On the offensive is Michael Jensen, an influential University of Rochester professor, who’s there to stump for efficient markets, a near-unanimous academic consensus. On the defensive is Warren Buffett, Graham’s most famous disciple and already recognized as one of the greatest investors alive.

Jensen starts. He reviews the academic literature, reciting a litany of studies showing no statistically significant evidence of skill. It sounds impressive. (I’m filling in the details here; it seems no copies of his speech survive on the Internet.) He ends by describing the fund industry as a coin-flipping game—enough coin-flippers and someone’s bound to enjoy a long streak that in isolation looks impossible.

Buffett responds. He asks you to imagine a national coin-flipping competition with all 225 million Americans. Each morning the participants call out heads or tails. If they’re wrong, they drop out. After 20 days 215 coin-flippers will have called 20 coin flips in a row—literally a one in a million phenomenon for each individual flipper, but an expected outcome given the number of participants. Then he asks, what if 40 of those coin-flippers came from one place, say, Omaha? That’s no chance. Something’s going on there.

Buffett argues “Graham-and-Doddsville” is just that place. He presents nine different funds that have beaten the market averages over long periods, all sharing only two qualities: a value strategy and a personal connection to Buffett. He emphasizes that they weren’t cherry-picked with the benefit of hindsight.

In closing, he boldly predicts “those who read their Graham and Dodd will continue to prosper.” The crowd goes wild. Later on, at the cocktail reception, everyone’s talking about how Buffett crushed Jensen.

How do we know Buffett was right? “From 1985 to 2012, Berkshire Hathaway’s book value would go on to grow 18% annualized, beating the S&P 500 by 7.4% annualized, with lower volatility.”

Some years later, Charlie Munger had this say about the academic theory that proved he and Warren were, in fact, mythological creatures (as relayed by an attendee of one of his speaking engagements):

“Efficient market theory is 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] And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.”

I’ve been working in the markets and directly with thousands of investors for the last fifteen or so years. I can promise you that markets are a lot of things at different times, but almost never are they anything even approaching the traditional definition of the word “efficient.”



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