Seth Klarman: What If Everyone was a Securities Analyst?

Seth Klarman offered up a simple thought experiment. What if everyone was a securities analyst, would the market finally be efficient?

Klarman’s thought experiment came in a response to Louis Lowenstein’s Searching for Rational Investors in a Perfect Storm. Lowenstein was questioning the existence of rational actors, purported by EMT, amid the Dotcom rubble. It’s reminiscent of Buffett’s The Superinvestors of Graham and Doddsville.

Klarman’s criticism of efficient markets is no surprise. He and his clients have thrived off of the inefficiencies for several decades.

His criticism gets to the root cause of why. Emotions. He tacks on an additional important point that probably gets overlooked by many. Brainpower has limits when you mix money with emotions.

Let me offer a simple thought experiment. Imagine that every adult in America became a securities analyst, full time for many, part-time for the rest. (With close to half the adults in this country already investing in stocks or mutual funds, this may not be quite as ludicrous as it sounds.) Every citizen would scour the news for fast-breaking corporate developments. The numerate ones would run spreadsheets and crunch numbers. The less numerate would analyze competitive factors for various businesses, assess managerial competence, and strive to identify the next new thing. Now, for sure, the financial markets would have become efficient. Right? Actually, no. To my way of thinking, the reason that capital markets are, have always been, and will always be inefficient is not because of a shortage of timely information, the lack of analytical tools, or inadequate capital. The Internet will not make the market efficient, even though it makes far more information available at everyone’s fingertips, faster than ever before. Markets are inefficient because of human nature — innate, deep-rooted, and permanent. People do not consciously choose to invest according to their emotions — they simply cannot help it.

So if the entire country became security analysts, memorized Ben Graham’s Intelligent Investor, and regularly attended Warren Buffett’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies, and investment fads. Even if they somehow managed to be long-term value investors with a portion of their capital, people would still find it tempting to day-trade and perform technical analysis of stock charts. People would, in short, still be attracted to short-term, get-rich-quick schemes. People would notice which of their friends and neighbors were becoming rich —  and they would quickly find out how. When others did well (if only temporary), people would find it irksome not to be participating and begin to copy whatever was working today. There is no salve for the hungry investor like the immediate positive reinforcement that comes from making money instantaneously.

A country of security analysts would still overreact. They would shun stigmatized companies, those experiencing financial distress, or those experiencing accounting problems. They would still liquidate money-losing positions as they were making new lows. They would avoid less liquid securities, since those are the last to participate in a rally and hard to get out of when things go wrong. In short, a country full of well-trained investors would make the same kind of mistakes that investors have been making forever, and for the same immutable reason — that they cannot help it.

Not being led by your emotions, as easy as it sounds, is hard to do even when you’re brilliant.

A Response to Lowenstein’s Searching for a Rational Investor in a Perfect Storm

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