(June 22, 2012) — The efficient market hypothesis is erroneous because it ignores the presence of mistakes that allow investors to beat the market, according to a memo from Oaktree Principal and Chairman Howard Marks.
The efficient market hypothesis concludes that efforts of motivated, intelligent, objective, and rational investors combine to cause assets to be priced at their intrinsic value, Marks writes in a memo to clients. It asserts that you can’t beat the market. “The truth is that while all investors are motivated to make money (otherwise, they wouldn’t be investing), (a) far from all of them are intelligent and (b) it seems almost none are consistently objective and rational,” Marks concludes. “Mistakes are all that superior investing is about.”
These are the elements that create what the industry refers to as “inefficiencies,” or, as Marks puts it, “academics’ highfalutin word for ‘mistakes.’”
In other words, he says that the only way that one side of a transaction can turn out to be a major success is to have the other side to have been a big mistake.
He writes: “There’s an old saying in poker that there’s a ‘fish’ (a sucker, or an unskilled player who’s likely to lose) in every game, and if you’ve played for an hour without having figured out who the fish is, then it’s you. Likewise, in every investment transaction you’re part of, it’s likely that someone’s making a mistake. The key to success is to not have it be you.”
According to Oaktree’s chairman, it is imperative to focus on the topic of investing mistakes because it serves as a reminder that the potential for error is ever-present. Thus, the individual investor is reminded that the importance of mistake minimization is a key goal. “If one side of every transaction is wrong, we have to ponder why we should think it’s not us,” Marks writes.
Furthermore, the memo indicates that most investment error can be distilled to the following failures.
1) Bias or closed-mindedness
2) Capital rigidity
3) Psychological excesses
4) Herd behavior
Those investors who position themselves to consistently take advantage of mistakes, such as the ones outlined above, are superior investors, Marks says.