I was reading an interesting blog post yesterday on Falkenblog that seemed to defend, in part, efficient market theory. One of the most basic tenets of efficient market theory is the assumption of investors as rational individuals. Further, this rationality is a function of the dissemination of information in our society so that all is known about a certain stock or equity instrument. The conclusion, then, is that the market efficiently distills this information, via the rational persons buying and selling of certain stocks.

Twenty five years in the stock business long ago dispelled any notion I learned in college that investors are anything close to rational, though the law of large numbers would seem to apply in that the more individuals participating in an individual issue the more likely the issue is likely to be priced properly. But history has, again and again, made it apparent that rational investors are a scarce commodity. Whether it be tulips, dot.com IPOs or houses, we are NOT rational, we are irrational. Lemming-like.

Mendelbrot theorized in “The Misbehavior of Markets” that long tails exist along any dispersion curve. With that statement he infers that catastrophic or unique events cannot be nearly encapsulated in any market theory for the exact opposite reason efficient theory draws its premise: Investors are rational.

For example, the premise during the dot.com bubble was something like this: things besides information can be efficiently distributed over the internet. I can remember looking at the business model for a dry dog food distribution operation and wondering how in the world a rational man could believe such a business model could work. It didn’t, even though the initial IPO skyrocketed, irrationally, to dizzying heights in early weeks of trading. And no the dot.com IPOs are resting in peace, after relieving millions of rational investors of their money.

Is the housing bubble any different? Well, maybe a little, as there was an overriding greed component to this bubble. Which brings me to my point: Investors aren’t rational, they’re greedy. Now don’t think for a second I believe greed is a bad thing, for it is greed, or the desire to earn a higher rate of return, that fuels capitalism. But this greed component often leaves up out on Mendelbrot’s long tail, and we have to find our way out of the long tail wilderness and back to the cozy equilibrium that exists in the main Bell curve structure.

But if Efficient Market Theory and it’s CAPM component are bunk, why is it taught at the university level with the reverence afforded holy books? Well, it’s partially true, until it comes to Long Tails, and then it falls apart. Boy, economics is tough stuff