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ple each seek profit, all trade between them should take place at the right
Price changes must occur, Bachelier reasoned, because of new infor-
mation. In other words, only unexpected news should change the prices
of stocks, houses, bonds, and other assets. Since price changes only come
from unexpected new information, Bachelier deduced the heretical claim
that it is impossible to predict price changes. Similarly, efficiency in the
housing market would suggest that “can™t lose” propositions are not
Interestingly, Bachelier™s idea, which is now the conventional wisdom,
was extremely unorthodox in his time. Even his advisors criticized his
40 The New Science of Irrationality

work, and his results were ignored to a large extent. Bachelier lived out
the rest of his life in relative obscurity, and he died without fame in 1946.
Not too long after his death, however, the concepts that Bachelier
invented were reformulated as the efficient markets hypothesis that swept
through universities and onto Wall Street in the 1970s.3
In the words of Burton Malkiel, author of A Random Walk down Wall
Street, the modern version of Bachelier™s insight is “Even a dart-throwing
chimpanzee can select a portfolio that performs as well as one carefully
selected by the experts.” Malkiel™s book was published in 1973, and it
was part of an enormous intellectual wave that restructured the invest-
ment world.4
If the efficient markets hypothesis is true, then an investor need never
fear buying overpriced stocks. According to the hypothesis, stocks are
never overpriced and markets can never be mean.
During the great bull market of the 1980s and 1990s, belief in market
efficiency and stock ownership soared. On the 1998 edition of Professor
Jeremy Siegel™s Stocks for the Long Run, the dust jacket proclaims,
“stocks are actually safer than bank deposits!” (Emphasis and exclama-
tion point in the original.)5
The idea that stocks are safer than bank deposits sounds a bit silly
today (and has been removed from the dust jacket of later editions of Pro-
fessor Siegel™s book). Nevertheless, if markets are rational, then Profes-
sor Siegel™s advice that “stocks should constitute the overwhelming
proportion of all long-term financial portfolios” might be reasonable.
If markets are not rational, however, then investors ought to worry
about buying stocks at irrationally high prices. They should also worry
about selling stocks at irrationally low prices. They should also be con-
cerned about the prices of houses, bonds, gold, and all assets.
The essence of the efficient markets hypothesis is realizing that a good
deal for one person implies a bad deal for the other. Thus, no one should
be willing to sell at irrationally low prices and no one should be willing
to buy at irrationally high prices.
The efficient markets hypothesis is a beautiful theory. Is it true?
Crazy World 41

If She™s Got Pictures, Deny It! . . .

It wasn™t me.
The pop star Shaggy gives this advice to men caught cheating. “Honey
came in and she caught me red-handed, creeping with the girl next door.”
The correct response to being caught cheating, according to Shaggy?
Deny by saying “it wasn™t me.” Even if caught on camera, Shaggy sticks
to his defense of “it wasn™t me.”
The great comic Lenny Bruce expressed a similar philosophy in one of
his routines: “There™s this kind of guy who says: ˜When I chippie on my
wife, I have to tell her, I can™t live a lie, have to be honest with myself.™ ”
To which Bruce replies, “Man, if you love your old lady, really love
her, you™ll never tell her that! Women don™t want to hear that! If she™s got
pictures”deny it! . . . Gee, honey, I don™t know how this broad got in
here”she had a sign around her neck, ˜I am a diabetic”lie on top of me
or I™ll die.™ No, I don™t know how I got my underwear on upside down or
Those who defend the efficient markets hypothesis use a similar tactic
of denial. In response to evidence of market irrationality, the response is
denial. (It wasn™t me.)
There are examples of market irrationality that appear as convincing
as photographic documentation of infidelity, and they are everywhere
around us. For example, financial bubbles have occurred in every society
throughout history that has had markets. The most famous case is the
seventeenth-century Dutch “tulipmania.” In 1635, at the height of specu-
lative frenzy, the price for a single tulip bulb exceeded that of a nice
house in Amsterdam.6
How could it be rational to buy a tulip bulb for the price of a house?
This seems particularly strange given that one tulip bulb can produce an
infinite number of baby tulip bulbs. While tulips may not breed like rab-
bits, they do multiply rapidly and thus high prices are impossible to
sustain. In fact, the Dutch tulip crash came swiftly, with some varieties
losing 90% of their value in a matter of weeks. (By comparison, after its
42 The New Science of Irrationality

peak in 2000, it took Sun Microsystems two years to lose 90% of its
The high price of tulip bulbs before the crash and their rapid decline
appear to be evidence of market irrationality. As we will come to see, true
believers of the efficient markets hypothesis deny that bubbles and
crashes imply that markets are irrational. (It wasn™t me.)
While markets continue to behave as they have for centuries, the
debate on irrationality has changed dramatically in recent years. The
field of behavioral finance has produced new, scientific evidence of mar-
ket irrationality. In many cases, the new studies provide statistical confir-
mation of folk wisdom.
Let™s take a look at some compelling evidence of market irrationality”
both historical and new”and the response of those who deny it. (If you
are already convinced that markets are irrational, you can jump down to
the section entitled “Why Professors Fly Coach and Speculators Own
Jets.”) I argue that it is impossible to prove that markets are irrational, but
the evidence is compelling. To which, of course, true believers in the effi-
cient markets hypothesis will reply: It wasn™t me.

Claim #1: Stock Market Crashes

On Monday, October 19, 1987, the Dow Jones Industrial Average lost
23%. By noon of the following day stocks faced a crisis where some
people feared a total collapse of the stock market. The U.S. Federal
Reserve, led by a recently appointed Alan Greenspan, rode to the rescue
by guaranteeing certain trades. The market recovered in the afternoon of
October 20.
Many people have investigated the 1987 stock market crash. Of note,
independent studies were performed by Professor Robert Shiller, the
author of Irrational Exuberance, and by his friend Professor Jeremy
Siegel, the author of Stocks for the Long Run.7
These two leading academics are often on opposite sides of the stock
Crazy World 43

debate. Professor Shiller argued (correctly so) that stocks were overval-
ued in the late 1990s. On the other hand, Professor Siegel has maintained
a uniformly positive view of stocks, before, during, and after the bursting
of the bubble in 2000. Because of their opposing views on the prospects
for stocks, they are often contrasted as leaders of the bear and bull camps.
When it comes to the crash of 1987, however, Professors Shiller and
Siegel agree. The crash was not caused by any rational factor such as a
news event. Professor Shiller summarizes his findings as, “No news story
or rumor appearing on the 19th or over the preceding weekend was
responsible for investor behavior.”8 Similarly, Professor Siegel writes,
“No economic event on or about October 19, 1987 can explain the record
collapse of equity prices.”9
As most of us know all too well, starting in 2000 the NASDAQ suf-
fered a decline that was less dramatic than the 1987 crash, but more
severe and longer lasting. Table 3.1 shows the performance of leading
stocks sometimes called the “four new horsemen of the NASDAQ.”
These figures suggest that either precrash prices were irrationally high
or postcrash prices irrationally low. When Cisco was priced at $80, the
evidence suggests that the stock price was irrationally high. Similarly,
when Cisco was trading at $8, after the bubble burst, the evidence sug-
gests that the stock price was irrationally low.
The Denial: The believers in the efficient markets hypothesis deny that
sudden price changes indicate irrationality. Furthermore, they claim that

TABLE 3.1 The Decline and Partial Recovery of the Four New Horsemen
of the NASDAQ
Bubble peak (2000) Post-bubble low Current (7/2004)

Cisco Over $80 $8 $23
EMC Over $100 $4 $11
Oracle Over $45 $8 $12
Sun Microsystems Over $60 Under $3 $4
Source: The Wall Street Journal
44 The New Science of Irrationality

Cisco™s stock price (and all other prices) were correct at the time. Thus,
they argue that the decline in Cisco™s price from $80 to $8 was caused by
unexpected information that was unknowable at the peak.
This claim is based on the fact that stocks discount the future. For
example, the value of Cisco in 2000 depends on China™s attitude toward
imports in 2010, so even small changes in investors™ expectations about
China™s future import policy can cause big changes in Cisco™s value.
Even huge price changes can be rational when nothing concrete changes
in the world.
Thus, even though Professors Shiller and Siegel cannot identify the
cause of the 1987 crash, it can be explained as a rational response to
expectations about the future. Since we can™t know what those expecta-
tions are, we can™t conclude that the sudden changes in stock prices are

Photographic Evidence: Asset Bubbles
in the Laboratory

In the real world, we can never prove that bubbles and crashes are caused
by irrationality. It is possible that real world crashes are caused by
changes in unknowable variables. To investigate bubbles, economists
have built artificial stock markets where everything is known. In these
laboratory markets, bubbles and crashes, if they exist, must come from
inside people.
In fact, Professor Vernon Smith and others have found that even artifi-
cial stock markets exhibit bubbles and crashes. In these experiments,
people trade a stock for real money. In contrast to the actual stock mar-
ket, the traders in these artificial markets know the true value of the stock.
Nevertheless, traders in these artificial markets push stock prices up to
irrationally high prices and then the prices crash.10
In the artificial markets, there is no explanation for the bubbles and
crashes other than the fact that they arise naturally as part of human
nature. True rational market believers argue that the markets are artificial
Crazy World 45

and, in the real world, people who trade at irrational prices would be
weeded out.
It wasn™t me.

Claim #2: Markets Are More Than Simply
Irrational”They Can Be Mean

Investors seem to have an uncanny ability to be wrong about investments.
We tend to be optimistic about stocks just before market collapses and
pessimistic just before bull markets. Consider the experience of U.S.
investors in the period from 1965 to 1981 as shown in Figure 3.1.
The Dow Jones Industrial Average ended 1965 at 969, and 16 years
later the index stood at 875. Almost an entire generation passed with the
stock market going absolutely nowhere. Near the end of this period, peo-
ple essentially forgot about stocks, and in 1980 only 5.7% of households
owned any mutual funds.11
In 1979, BusinessWeek printed its now infamous “Death of Equities”
Dow Jones Industrial Average








FIGURE 3.1 A Generation without Stock Market Gains
Source: Dow Jones
46 The New Science of Irrationality

issue suggesting that investors avoid stocks. The cover image was a
crashing paper airplane, created from a stock certificate. Stocks were
destined to be bad investments, opined the magazine, for the foreseeable


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