Investor Mistakes and How Efficient Markets Really Are

by: Larry MacDonald

Seven of the top ten research papers downloaded over the past 60 days from the Social Science Research Network [SSRN] Web site relate to finance. What’s perhaps more interesting is that many of these finance papers on the top ten SSRN list are about investors making mistakes.

In ‘120 Errors in Company Valuations, ‘ Spanish professor Pablo Fernández lists and classifies 120 errors in company valuations performed by financial analysts, investment banks and financial consultants. In ‘We Don't Quite Know What We are Talking About When We Talk About Volatility,’ Daniel G. Goldstein and Nassim Nicholas Taleb claim finance professionals confuse mean absolute deviation with standard deviation in discussions of volatility. In the ‘The Age of Reason: Financial Decisions Over the Lifecycle,’ four academics claim that financial sophistication varies with age – the young and old shortchange themselves on their financial decisions.

It makes one wonder just how efficient financial markets are. Current prices in the market may embody all available information, but what if the information has been slotted into flawed formulas and/or simply added up wrong? Is there an opportunity for precise and painstaking investors to outperform the crowd?

Then again, the No. 1 download of all time (not just the last 2 months) from the SSRN Web site is “Market Efficiency, Long-Term Returns, and Behavioral Finance” by Eugene F. Fama, dean of the Efficient Markets Theorem (NYSEARCA:EMT) school. Could there be something in his writings (or other EMT papers) that undermines the notion of diligent investors doing better? For example, if investors' errors are normally distributed, then could one not argue that they average out to the correct result?