The Drunkard’s Walk

On 29 March 1900, at the University of Paris, a young mathematician named Louis Bachelier defended a thesis called The Theory of Speculation. He had studied the prices of French government bonds on the Paris exchange. And he reached a conclusion that interested nobody at the time: prices move at random. Tomorrow’s move doesn’t depend on yesterday’s, just as a drunk’s step doesn’t depend on the one before. A drunk can end up anywhere. Where, nobody can say in advance. Not even the drunk.

Bachelier’s supervisor was the great Henri Poincaré. The work got a modest mark, and one respected colleague, so they say, grumbled that there was too much finance in it. Bachelier spent his whole life teaching in the provinces. The thesis was remembered only half a century later. American economists stumbled on it and realised that a Frenchman had described, fifty years before them, what they were only just getting close to.

No prophet is accepted in his own country, as everyone knows. Or in his own university.

A Monkey with Darts

If prices walk like a drunk, the conclusion is an awkward one. No expert can consistently guess which shares will go up.

In 1973 a Princeton professor, Burton Malkiel, wrote a book about it. And he put in a line that has since been quoted millions of times: a blindfolded monkey throwing darts at a newspaper’s financial pages could pick a portfolio as good as one carefully chosen by experts.

The Wall Street Journal decided to test it. Members of staff threw darts at the table of share prices, professional fund managers picked shares themselves, and after six months the results were compared. It was meant to run for a month. It went on for fourteen years, a hundred and forty-two rounds. On average the experts won.

But Malkiel spotted a catch. When the paper printed the experts’ picks, readers rushed to buy those shares, and the price rose from the publication alone. He recalculated the results using prices from the day before the article came out. The experts’ advantage, he says, disappeared completely.

The monkey, notice, didn’t charge a fee.

That doesn’t mean there are no clever fund managers. It means it’s hard to tell the clever ones from the lucky ones. And you’re the one who pays the fee for that difficulty.

The Prophecy That Fulfils Itself

But the drunkard’s walk isn’t the whole truth about the market. Sometimes prices don’t wander, they run. All in the same direction. And they run because everyone has come to believe in it.

Gambetta says something interesting about reputation. A good reputation spreads by itself from client to client, fast and gathering speed, like the slander in Rossini’s The Barber of Seville. There are trades where it matters especially. Doctors, for example. And bankers—they, Gambetta notes, are themselves a kind of protection firm, only they protect money. Once people stop believing a bank is sound, the bank collapses because of it.

See how it works? The prophecy fulfils itself. A bank is sound as long as people believe in it. Once everyone decides it’s unsound and comes for their money, it collapses and so proves them right. A share goes up because everyone believes it will go up, and they buy. It goes up—so they were right. They buy more. Until one day the buyers run out. Then the fall proves right the ones who sold first.

In 1981 Robert Shiller showed that American share prices jump about far more than later changes in dividends justify. If people valued only companies’ future earnings, prices would move much more calmly. So there’s something in prices beyond the arithmetic. Moods, fashion, fear, what the neighbours believe. Most of the time the market walks like a drunk. And sometimes it stampedes with the crowd.

Paper Tiger

We have our own prophecy that lives a life of its own. Critchley retells the conclusion of a researcher, Peter Reuter, who studied the American Mafia using data on its real income. Reuter suggested that the Mafia might already be a paper tiger. It sensibly collects income from its reputation. But it no longer keeps up the strength that once built that reputation.

The conclusion is disputed, and Critchley presents it as one point of view. But the mechanism is clear. A reputation, like a share price, can stay above what’s behind it for a long time. As long as people believe in it. The shopkeeper pays because everyone pays and everyone believes not paying is dangerous. And how much strength there really is behind that belief, nobody checks. The man who checked and got it wrong pays far too dearly.

Who Profits from Inefficiency

And one last paradox you need to know. Two American economists, Sanford Grossman and Joseph Stiglitz, showed in 1980 that if the market were perfectly efficient, nobody would have any reason to gather information, since the price would already know everything. But if nobody gathers it, the market can’t be efficient. So the market is always a little inefficient. Just enough to pay for the work of the people who study companies.

Hence the honest conclusion. You can beat the market. But you’ll pay for it with work, knowledge and risk. And most of the people who promise to do it for you are simply charging you a fee for luck.

Don Vincenzo once heard out a young man from the bank. He was proposing to put the laundries’ money into a fund where the manager “picks the best shares”. The Don asked how much the manager took. Two per cent a year, the young man answered. “And how much does he make over the market?” Last year, four. “And the year before?” Minus one. The Don thanked him politely. Then he said to me, “If I’m going to pay two per cent to a man who guesses right one year and wrong the next, I’d rather pay it to you. At least you bring the coffee.”

The Bottom Line

Want more than the market? Pay with work, knowledge and risk. Don’t want to? Take the whole market and don’t pay for somebody else’s luck.