The Poker Face of Wall Street

FINANCE BASICS ♠ 61

that fit well with the rest of their investments. Some people buy a shirt because they like it; other people think about the other clothes they have that it would go with and for which they don’t currently have the right shirt. Markowitz said that investors shop for a wardrobe, not a shirt. But he didn’t say that investors match their portfolios to broader life assets, such as careers, houses, and spouses. MPT says that financial investments are evaluated in connection with all other financial investments, but not with everything else.

MPT does not require that markets be efficient. Every investor could have her own views on security prices and select the appropriate portfolio, given those views. Investors can be wrong about the statistical properties. Securities can be mispriced. Therefore, MPT can never be proven right or wrong, except in the irrelevant sense as a statement about investor psychology (in which case it’s clearly false—investors care how much money they made or lost, not about abstract statistical properties). MPT is important because important features of the market are explained most simply if it’s true. In other words, security prices move as if investors care about the statistical properties of their portfolios, even though investors don’t.

A few years later, Eugene Fama made an essential advance to put finance on a sound basis. He investigated the results of assuming that security prices incorporate all information—in other words, that you cannot use any information to predict future security price movements. Without the Efficient Market Hypothesis (EMH), you can explain anything as a disagreement among investors. He sold stock A to her at $50 because he thought it was worth less than $50 and she thought it was worth more. Stock A went to $52 because more investors wanted to buy it. If you can explain anything, you explain nothing. Whatever happens, your theory covers it, so it never has to be changed. Of course, it also cannot predict; anything is possible in the future.

So Fama asked, “What happens if all investors agree about statistical properties of securities and try to form good portfolios?” Then he checked to see whether security prices moved according to that prediction. It’s important to realize that no one thought the market was efficient; it was just a way to study things rigorously. If Fama