Warren Buffett: Efficient Market Theory Is Bullsh*t

Summary

In this insightful conversation, Warren Buffett and Charlie Munger critique the Efficient Market Theory (EMT), discussing its decline in relevance and how value investing and business valuation remain essential to successful investing. They reflect on the inefficiency of academic approaches to investing and emphasize the importance of understanding a business's intrinsic value. They also share their views on long-term market expectations, cautioning against overly optimistic growth projections and urging a realistic approach to future investment returns. Ultimately, they advocate for a measured, pragmatic investment strategy grounded in reality and fundamentals.

Takeaways

• 😀 Market efficiency is generally true, but it does not support the Efficient Market Theory (EMT) as an absolute approach to investing.
• 😀 The Efficient Market Theory hit its peak in popularity about 20 years ago, but has been increasingly discredited since then, especially in the academic world.
• 😀 Even though markets are generally efficient, it's hard to find securities that are inefficiently priced, particularly in today's market.
• 😀 Business schools are now teaching more about valuing businesses, moving away from the dogma of Efficient Market Theory that dominated in the past.
• 😀 The core of investing is about valuing businesses—identifying what a business is worth and buying it if it is undervalued, rather than relying on theoretical models like EMT.
• 😀 Many finance professionals, particularly those with PhDs, struggle to value businesses properly and often default to EMT as it’s easier to teach and understand.
• 😀 Even highly qualified professionals often avoid teaching business valuation because they lack the practical expertise in doing so.
• 😀 The practical inefficiencies of businesses, such as Berkshire Hathaway, were overlooked for a long time, demonstrating that even theoretically efficient markets can miss opportunities.
• 😀 For the average investor, regular investment in low-cost pools, such as index funds, is often the best strategy for long-term growth.
• 😀 The growth expectations of the equity market should be adjusted—expectations of high returns similar to historical trends (e.g., 15% per year) are unrealistic given current economic conditions.
• 😀 The long-term rate of return from investments in equities must decrease due to global wealth growth constraints and the increasing size of major equity markets like the U.S. market.
• 😀 The real wealth generated by businesses (such as the Fortune 500) is limited to what the businesses actually produce—there is no magical transformation of that wealth into perpetual growth.

Q & A

How does Warren Buffett view the Efficient Market Theory (EMT)?

Warren Buffett believes that while the market is generally efficient in many ways, the Efficient Market Theory (EMT) is flawed. He suggests that adopting it as an approach to investing was a mistake, comparable to believing the Earth is flat. He claims EMT has been discredited over the last couple of decades and that it failed to acknowledge the importance of valuing businesses.

What is the main criticism of the Efficient Market Theory according to Buffett and Munger?

Buffett and Munger criticize EMT for oversimplifying the complexities of investing. They argue that it fails to address the importance of evaluating and valuing businesses, which is central to successful investing. Additionally, it disregards the possibility of inefficiencies in the market, which can present opportunities for savvy investors.

What is the state of Efficient Market Theory in academic circles today?

Efficient Market Theory is no longer as dominant in academic circles as it was 15-20 years ago. Buffett notes that it has been largely discredited, and business schools have started to recognize the importance of valuing businesses instead of relying solely on EMT. It is no longer the unquestioned dogma it once was in finance departments.

Why is it difficult for academics to move away from Efficient Market Theory?

It is challenging for academics to move away from EMT because it has become entrenched as a central belief within finance departments. Many professors have spent years teaching and researching EMT, and admitting that it is wrong would mean revisiting and revising their entire body of work, which is a difficult and uncomfortable process.

How do Buffett and Munger feel about the future of the Efficient Market Theory?

Buffett and Munger are confident that the more rigid, 'hard-form' version of the Efficient Market Theory will fade away. Munger refers to this change as inevitable, noting that the 'Old Guard' will eventually give way to more accurate, realistic theories about market efficiency. They believe that the core idea of the market being 'roughly efficient' will remain, but the exaggerated claims of EMT will eventually disappear.

What is the practical advice Buffett and Munger give to investors who are new to managing money?

Buffett and Munger suggest that for average investors looking to manage money over a long period, low-cost investment options like index funds are a good choice. They emphasize the importance of keeping costs down while investing regularly. However, they also caution that finding great investment opportunities can be more difficult in today's market, and they do not have a one-size-fits-all recommendation.

What does Buffett say about Berkshire Hathaway as an investment option?

Buffett admits that he has a significant portion of his wealth invested in Berkshire Hathaway, which he is comfortable with because of his belief in the quality of its businesses. However, he also advises against recommending it to others at its current price, as he did not purchase it at that price and believes it may not be as attractive to new investors.

What are the challenges Buffett and Munger face when investing with large sums of money?

Buffett and Munger find it more difficult to identify attractive investment opportunities when managing large sums of money. In contrast, with smaller funds, they might have more flexibility and access to smaller, undervalued opportunities. Currently, they are focusing on bigger ideas, but they do not have any clear 'no-brainer' investments to recommend.

What are Buffett and Munger's thoughts on the long-term returns from investing in equities?

Buffett and Munger suggest that future long-term returns from equities are likely to be lower than what people have experienced in the past. They argue that corporate profits cannot grow faster than GDP indefinitely, and therefore it is unrealistic to expect high returns from equities in the future. They emphasize the need for investors to adjust their expectations accordingly.

How do Buffett and Munger address the relationship between corporate profits and GDP growth?

Buffett and Munger point out that corporate profits are unlikely to grow at a faster rate than GDP in the long term. They explain that corporate profits as a percentage of GDP are already high, and it is unsustainable for profits to continually outpace GDP. As a result, they believe it is unrealistic for equities to generate the high returns that investors have come to expect.